August-October in mutual fund/ETF-land

 August has traditionally been a slow month in financial markets, for two reasons:

–Europe, including European factories and stock markets, pretty much closes up for the month and everyone goes on vacation

–on this side of the Atlantic, high-level Wall Streeters head for the Hamptons, leaving behind cellphone numbers and assistants who have less authority to make independent decisions–and who certainly don’t execute changes in strategy.

Yes, in today’s world the EU is much less significant than it used to be and Industrials as a group are a mere shadow of their former selves.  But the vacation effect is still a powerful soporific.


In September, mutual fund/ETF minds turn toward the end of the fiscal year, which occurs on Halloween.

Mutual funds/ETFs are special-purpose corporations.  Their activities are restricted to investing; they’re required to distribute to shareholders as dividends each year virtually all of the profits they recognize.  (In return for these limitations, they’re exempt from corporate income tax on their gains.)

About thirty years ago, with government encouragement, the industry moved up the end of its fiscal year from December to October.  This gave funds two months post-yearend to put their books in order and get checks in the mail in December, so the IRS could collect income tax from holders on those distributions in the current year.

Because of this, fund/ETF preparation for the October 31st yearend typically begins in early or mid-September.  It invariably involves selling.

How so?

For reasons that completely escape me, mutual fund holders like to receive distributions. They regard it as a mark of success.  And they seem to like a payout of around 2% -3% of asset value.

For most of the year, the tax consequences of their decisions are not in the forefront of portfolio managers’ minds (strong industry belief is that taxes are tail that shouldn’t be allowed to wag the portfolio dog).  As a result, distribution levels most often require fine-tuning.  This means either selling to realize an additional gain, or selling to realize an additional loss.  Either way, it means selling.

At the same time, this occurs close enough to the end of the calendar year that PMs often use the opportunity to begin to make major portfolio revisions in anticipation of what they think will play out in the following calendar year.  This means more selling.


October often sees the beginning of a rally that lasts into December, as the fiscal yearend selling pressure abates.  Accountants play a role here, as well.  Every organization I’ve been in requests that PMs avoid trading, if possible, during the last two weeks of the fiscal year.  That’s to avoid the possibility that a trade has settlement problems and isn’t completed until the beginning of the following fiscal year.  PMs mostly play only lip service to requests like this, but it does ensure that purely tax-related selling is over by mid-month.


a(n important) footnote

Like any other corporation, if a mutual fund/ETF has net losses, it carries them forward for use in subsequent years.  Virtually every fund/ETF has been saddled for years with large tax loss carryforwards generated by large panic redemptions at the bottom of the market in 2008-09.  These had to be offset by realized gains before a distribution would be possible.

Last year was the first time that enough funds/ETFs had used up losses and were able to make distributions.  During the second half of last September, the S&P 500 fell by about 5%, before rallying from  early October through late November.


strategy for 2014: yearend tax selling

I won’t be writing my strategy thoughts for 2014 for a few weeks.  However, it’s not too early for all of us to be thinking seriously about yearend tax selling, both as a market phenomenon and as a part of our personal portfolio management.

A disclaimer before I begin:  I’m an investor, not a CPA.  To get all the ins and outs of the capital gains tax rules, read the appropriate IRS or other tax authority publications.

why it happens

For most taxable investors in the US and mo,st other areas I’m aware of, the tax year ends with the calendar year on December 31st.  (One major exception is mutual funds and ETFs.  Their tax years generally end on October 31st–giving them time to close their books and make required distributions to their customers–who must pay tax on these receipts–before 12/31).

Investment gains are taxable once they’re “realized,” i.e., once the investment is sold.  But tax is due only on the net gain–that is, after subtracting any realized investment losses–not the gross amount.

In an ideal world, we’d all be doing tax planning constantly.  The reality is different.  Professionals believe (correctly, in my view) that taxes aren’t the most important elements of portfolio construction, so sometimes, in my attention, they pay shockingly little attention.  The rest of us just wait around until the end of the tax year approaches.

the phenomenon

For taxable professionals, like insurance companies or banks, who hold “balanced” portfolios of several asset classes (stocks, bonds, alternatives), they’ll try to match sales of, say, money-losing bonds and money-making stocks so that the net effect is zero taxable income.

Or it may be that guidelines, either internal or regulatory, require them to prune large winning bets.  In that case, they’ll scour the rest of the portfolio for anything with a loss attached to it and heave that overboard–just to knock down the tax bill.

This all occurs in the six-week period from early November to mid-December.  Clunkers may be sold more aggressively but there’s also downward pressure on winners as well.

For individuals, the main focus of selling tends to be small-cap names that have performed poorly.  They tend not to be sold with a very light touch.  Instead, individuals typically dump them out without much/any regard for price–just to get rid of them.  This sets the stage for the “January effect” as these beaten up stocks rebound after the first of the new year.

taking advantage

If the advent of tax season isn’t the reason for doing some serious thinking about what positions we want to take into 2014, it can at least be the occasion for doing so.  For example, serial clunkers in our portfolios tend to find ways to make our eyes skip over them when we examine our holdings.  It’s much harder for them to hide when we’re specifically looking for red ink to make use of

Similarly, we all love our big winners.  But we also have to .remember that at some point the risk of holding a (for us) humongous position outweighs the possible future gains.  Yearend is a good time to consider whether to trim.  Don’t be like a hapless acquaintance during the internet bubble who rode JDS Uniphase from $ 3 to $1000 (a position of $100,000 to $30 million) …and back down again.  Think Mark Cuban instead.

A more aggressive tactic would be to shop around for rebound candidates among this year’s big losers.  They may be pushed down by, say, another 10% before the year is out as holders shove them out the door to take tax losses.  This is not my style, so I have no words of advice, other than that you better do your homework before taking the plunge.

“wash” sales

One more point:  You can sell a position that’s deep in the red to recognize the loss and then buy it back.  But the IRS says you have to wait 30 days before the buyback to be able to take the loss.

I’m not a fan of the tactic, although some people may be able to do this successfully.  For me, it would be perpetuating the delusion that I haven’t made a mistake.

yearend tax selling

tax selling…

It’s a little late in the day to be writing about this topic, which is perhaps indicative of my ambivalent attitude toward the idea.

…by professionals

Professional portfolio managers, by and large, don’t pay much attention to tax selling, for several reasons:

–we’re trained to think that tax considerations are much less important than company fundamentals in making buy and sell decisions,

–many of the portfolios we manage are tax-exempt–in fact, clients sometimes stress to us that they’re indifferent about whether profits come as ordinary income or capital gains,

–company fundamentals are way more important

–most professionals spend all their time watching their clients’ money, not their own.

Tax considerations aren’t nothing, though.

Mutual fund managers have always got to keep an eye on the size of the profits they generate, since virtually all of the have to be distributed as taxable gains to their shareholders.  In addition, for many individuals, investment gains–either through their own active management or from distributions from mutual funds or ETFs can be a significant source of (taxable) income.  So they’ve got to be at least aware of how big that income is.

…for individuals like us

As an individual, I have four general thoughts:

1.  I live in a state, New Jersey, where the state taxes on investment gains are very high.  So I try–earlier than the last day of the year–to flatten my gains by taking losses.

2.  Combing the portfolio for losers forces me to consider carefully any security that is below my cost.  I often find that the process forces me to  recognize that the fundamentals of a given security are bad (we’re all good at deceiving ourselves in this regard).  So I end up selling for fundamental reasons.  The search for tax losses is only the occasion, or the trigger, for my sale.  In some cases, the loss can be an ego-saving excuse.  In my view, that’s the main value of the process.

3.  As peculiar as it sounds at first, a loss has a financial value for a taxable investor.  It’s the ability to shelter gains on other investments from taxes.  For a losing stock that has little purpose in a portfolio, recognizing that value sooner than later is probably wise.

4.  Not selling a stock because you have a big capital gain is an easy–but sometimes painful–mistake to make.  So I have to do a sanity check on winners, as well.

I have a friend who had a very large inherited position in GE when it was a $40+ stock in 2007.  At the time, I wasn’t a fan of GE.  I thought Jack Welch was a brilliant self-publicist who had convinced the financial press that hamburger was filet mignon and who had left Jeff Immelt a horrible mess to clean up.  My view of Mr. Welch hasn’t  changed; my respect for Mr. Immelt has grown.

My friend said she felt she couldn’t sell because she depended on the dividend income from the shares.  She also said she had a cost basis of only a couple of dollars, so taxes would take huge bite (25% or so) out of her capital.  Since then, however, GE slashed its quarterly payout from $.31 to $.10–it has just been raised to $.17–and the stock now sells for $18.

In hindsight, it would have been a lot better to at least diversify away from GE and pay the taxes.  (An unbelievably gutsy investor could have bought the stock back for less than $6 in early 2009, but stuff like that never happens in real life.)