The end of the year brings one of the more confusing aspects of mutual funds for investors. Fund owners are given a distribution, usually sometime in December. The distribution comes from the dividends and yields paid to the fund from the stocks it holds. The fund is required by law to pass these gains onto its shareholders.

The term “distribution” is a little misleading, because instead of passing these dividends on to the mutual fund client, the fund keeps the cash and reduces the value of the fund shares. Then it issues additional share to fund investors to make up for the difference.For example, on Dec. 15 Fund ABC has an Net Asset Value (NAV) of $10 per share. Investor Bob owns 10 shares for a total account value of $100. 

On Dec. 16, Fund ABC issues a 10% distribution. Investor Bob still has $100 in his account, but he now owns 11.11 shares valued at $9.

Investors who are not aware of how these distributions are handled can be shocked when they check the share price of a fund they own and find that it dropped dramatically for no apparent reason. Often they fail to see that the price decrease is offset by owning a greater number of shares.

The accompanying chart illustrates this problem. The red arrows mark two separate December distributions. In each instance, the price of the fund appears to plunge. In reality, anyone owning the fund would have the price decline offset by an increased number of lower-price shares. So the net effect on an account balance would be zero. But it can cause a panic for an investor who does not realize what has taken place.

Of course, there can also be tax implications with these phantom distributions. In qualified accounts like IRAs or 401Ks, the distribution is essentially a non-event. But in a taxable account, the distribution is counted as income. That means in the example above, as far as the IRS is concerned, Investor Bob received an extra $10 in income on which he must now pay taxes. It doesn’t matter than his account value did not change. 

In this example, the amount is not significant. In real life, phantom distribution income can be major. In funds with high returns and high portfolio turnover, distributions can be 20% or even more. That can result in an unexpected hefty tax burden for someone caught unaware. 

Some investors avoid the distribution problem by finding out when a fund historically makes its distributions and then selling ahead of that date. Of course the investor who takes this approach must then wait the required period before buying back into the fund or he faces the tax implications of a wash sale.

F.S.

If you would like an investment strategy that attempts to minimize risk but still provides the opportunity for solid growth, check out the Foundation Strategy from Strategis Financial Group.  This actively managed strategy is designed to take advantage of the experience and expertise of some of the nation’s best mutual fund managers. To learn more, call me, Flint, at 800-279-3377.

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