Our Year-End 2006 Investment Tactics

One of the long-standing drawbacks to the mutual fund structure is the treatment of actual realized gains – gains and other income are distributed to all fund shareholders as of a certain date, not to individual shareholders in accordance with their actual results in the fund.  While we are always on the lookout to harvest losses for tax purposes (happily, right now, there are very few of those), large distributions from a number of mutual funds in late 2006 created other opportunities and challenges for year-end trading.  Here’s what we have done.

As the end of each year approaches, we ask ourselves the following questions:

1. What should we do with new cash - postpone investing it in a preferred fund until after the record date for taxable distributions, or buy a replacement fund now?

2. When should we sell a position to realize a loss for tax purposes…or, even at a taxable gain, in order to avoid a large taxable distribution?

Postponing With New Cash

When clients add new cash to their portfolios near year end, we often wait until after the record date to purchase funds with expected distributions greater than 2%.  If this would result in a client remaining in cash for periods longer than five business days, we purchase a replacement fund (often an ETF which is not expected to distribute a capital gain).  We will sell the replacement fund, if any, and purchase the preferred fund after its distribution has occurred.

Deciding When to Avoid a Fund’s Capital Gain Distribution/Tax Loss Harvesting

Selling at a loss is valuable for tax purposes because it offsets the tax on a gain or on some other investment, either in the current year or at some point in the future.  Throughout the year, we comb through all of our clients’ positions to identify losses of sufficient size to warrant realizing the loss by selling and purchasing a replacement fund.  After 31 days (as required by the wash-sale rule), we can sell the replacement and repurchase the preferred fund.  If this sale and repurchase can permit us to side-step a taxable year-end fund distribution, it’s a double win.

We try, of course, to avoid selling positions in a taxable account if that would result in realizing a gain, particularly if the gain is short-term.  However, by issuing a distribution, a mutual fund would force our clients to realize income (dividend and/or long- or short-term capital gain), even if they do not sell the position.  We are therefore faced with the choice of voluntarily realizing a gain (by selling in advance of the distribution) or involuntarily realizing income (if we just stayed in the fund for the relevant date).  If the unrealized gain in the position is small enough, selling that position may result in less actual tax to be paid than would occur if we just did nothing. 

The large-ish distributions of late 2006 provided an additional benefit for clients for whom we were moving real estate or commodities holdings from tax-deferred to taxable accounts in our efforts to maximize the future tax efficiency of these holdings.  Given our expectation in early December that a number of funds would have fairly large distributions, we evaluated voluntarily realizing short-term gains in non-real estate funds before their record date in order to avoid the distribution and facilitate relocating that holding to a tax-deferred account.  This freed up capital in the taxable account to purchase real estate or commodities there.  Corresponding amounts of commodities or real estate in tax-deferred accounts could thus be sold (tax-free) and their proceeds used to purchase substitute assets for those originally sold in the taxable account.

Behind The Scenes

Over the past few years, the markets have been very strong and the opportunities to harvest losses outright have been few.  Further, capital gains distributions have generally not been large enough to warrant voluntary realization of gains in order to avoid them.  2006, however, was exceptional in this latter situation.  Distributions last December were scheduled to be large enough, in some cases, to make taking even short-term gains worthwhile.  And, we did.