The end of the year is an important time for mutual funds. While the term itself seems stodgy and from a quaint time of martini-sipping businessmen before the advent of the state-of-the-art ETF, mutual funds are still an essential backbone of American finance. Since 401ks still require mutual fund investments, these funds dominate the investment industry. As such, their odd and admittedly inefficient structures dominate financial markets.
One of the odd aspects of mutual funds is that they are required to distribute all income to investors by the end of the year. For bond funds this is obviously a big deal, since bonds tend to see most of their gains in the form of coupons (i.e., income that the bonds owe to bond buyers) and not in the form of capital gains (which are not necessarily given to mutual fund shareholders in the same way). The form of these distributions is the “year-end special distribution”, and it’s an important accounting and taxation issue for both owners of mutual funds and the back offices (i.e., the accountants and administrators) that manage these funds.
Year-end special distributions are a lump sum that in many cases can be a tremendous amount of the fund’s total assets. For instance, Columbia Acorn USA Fund (LAUAX) recently got some bad press in U.S. News and World Report because it was planning to distribute around $5 per share in a special payout, which is 25% of its current share price. That means mutual fund owners who own this fund outside of a tax advantaged account will end up paying 15% long-term capital gains taxes on that distribution. At the same time, that distribution won’t compound, because it will no longer be invested in the fund. You can re-invest it in the fund, but the tax issues remain, and the inefficiencies of such a system are obviously undesirable.
ETFs, however, are not required to distribute income in the form of year-end special distributions, which is one reason why they have grown in popularity and silently taken over not only the mutual fund industry, but the investment world as a whole.
Still, for as long as mutual funds remain the only option for 401ks, the year-end effect on markets and on individual mutual fund investors remains a specter over markets. This is also a challenge that mutual fund managers need to spend more time on; how can they optimize their funds and portfolios to avoid these tax issues while also maximizing returns?