What stocks to invest in
Mutual funds are corporations of a special type. In return for agreeing to limit their activities to portfolio investing and to distribute basically all their net realized gains to shareholders, mutual funds are exempt from paying corporate tax on those profits. Net here means after subtracting realized losses. Realized means that the winning/losing stock has been sold and the gain/loss recorded in the fund’s accounts.
Typically, distribution of gains occurs once a year, in November or December.
In my experience, almost no one other than the fund manager thinks much about the profits and losses imbedded in a fund, whether realized or unrealized. There are certain situations, though, where they can be important.
In my career, I’ve turned around a couple of global mutual funds where the single most valuable asset on the day I arrived was the funds’ realized tax losses. They allowed me to trade the portfolio aggressively without shareholders incurring any tax liability.
Most funds today are in the opposite situation. Given that the S&P 500 is at all-time highs, funds tend to have large accumulated unrealized gains. Tax on these gains is only due when stocks in the portfolio are sold and profits distributed to shareholders. Also–and this is important–the tax is the obligation of the person who receives the yearend distribution. That’s not necessarily the same as the person who enjoyed the rise in net asset value of the fund.
sales and redemptions
The potential per share value of losses falls if the fund is having net sales (meaning the number of outstanding shares is increasing), and rises if it is having net redemptions.
The potential per share tax obligation of gains also falls if the fund is having net sales and rises if it is having net redemptions.
the Sequoia situation
If the Wall Street Journal is correct, Sequoia is experiencing substantial net redemptions. If it has to sell stocks where it has large gains in order to meet these outflows, it could be setting the stage for shareholders who stay loyal to the brand to incur a large income tax liability this year.
What the firm appears to be doing to reduce this burden on remaining shareholders is to meet large (over $250,000) redemptions mostly by distributing shares of stock from the portfolio rather than by (selling them and distributing) cash.
While this may be unusual and inconvenient to redeeming shareholders, it does not hurt them, since their cost basis on in-kind distributions is not the fund’s. Rather, it’s the closing price on the day they receive the stock. At the same time, distributing stock protects shareholders who don’t redeem from getting a whopping income tax bill at yearend.
– What stocks to invest in