Updated on 03.31.07

Answering A Few Questions From Mutual Fund Week

Trent Hamm

Here are three interesting questions sent in by readers of the series of mutual fund posts this week.

I don’t understand how the companies that run these funds make enough money to make it worthwhile after ads, expenses, and so on.

When you look at a mutual fund on Morningstar, you’ll see two key numbers: the expense ratio and the total assets. Multiply them together and you’ll get a pretty good sized number. Take the Vanguard 500, for example. It has an expense ratio of 0.18%, but it has $118,883,000,000 in assets. Multiply them together and Vanguard is netting $214 million a year out of the fund. Even with a small expense ratio, a fund can bring in a lot of money. An investment house does have a lot of expenses, but with that kind of money coming in, they can easily afford what they need to do and bring in some serious cash.

How do I balance a mutual fund portfolio if it’s invested in several different places?

The easiest way is to focus each account on a specific piece or two of your portfolio. This is especially easy if these investments are in 401(k) or Roth IRA accounts where you can move around the balance without incurring tax penalties. Sometimes an account won’t have enough in it to cover a single piece of your desired portfolio; in that case, you should finish out that piece in another account.

You keep mentioning capital gains tax. How do they work?

A capital gains tax is a tax that the government charges you when you sell an asset and make a profit on it. If you buy a stock at $10 and then sell it at $15, you have to pay capital gains tax on that $5 difference. Typically, capital gains tax are filed as part of your income tax return and are typically subject to a lower tax rate than normal income. More importantly, if you have a capital loss in a given year, you can subtract that loss from the gain and only pay taxes on the overall gain.

Sometimes you are subject to capital gains tax even if you don’t sell anything from a mutual fund. This is called turnover and occurs when a fund does a lot of selling of assets during a year without replacing these sales – they instead distribute the fund’s gains to the holders, putting them on the hook for capital gains. This distribution usually reduces the value of the fund, so it basically means that part of your investment can be handed right back to you and you have to pay capital gains tax on it.

Here’s an example of why turnover can be bad. Let’s say you bought $70,000 worth of a fund. It goes to $100,000. Two days later, the annual distribution occurs. You get a check for $30,000 and your fund’s value drops back to $70,000. You’re then on the hook for the capital gains tax on that $30,000 whether you like it or not.

One way to avoid this is to look for funds with low turnover, because those are much less likely to do a distribution (and thus cost you money).

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  1. Sarah says:

    Let’s say you bought $100,000 worth of a fund. Two days later, the annual distribution occurs. You get a check for $30,000 and your fund’s value drops to $70,000. You’re then on the hook for the capital gains tax on that $30,000.

    I’m pretty sure this isn’t right. In this scenario, your shares of the fund haven’t appreciated at all (you paid $100K; two days later the fund returns you $30K, leaving you with $70K in the fund, for the same total of $100K). You have nothing to pay taxes on because you haven’t recognized and realized any gains. The people who would pay taxes would be the folks who bought into the fund earlier. They would have recognized gains which would be realized by the sale of the fund’s assets.

    Turnover actually simply refers to the buying and selling of stocks by the fund. It’s bad primarily because each transaction has a cost, and you indirectly must pay your share of those costs. A distribution is just another (undesirable) result of turnover.

  2. mh1 says:

    I’ve been meaning to put forth this question to you for a while, but have been waiting for a relevant post. Regarding dividends (which I assume you’re speaking of by mutual fund payout) in a Roth IRA, if these funds are automatically reinvested, does the addition of the payout to your portfolio count toward your IRA cap (e.g. $4000/yr)?

  3. MossySF says:

    Sarah, Trent is right. I moved a bunch of money into Vanguard funds October last year and had to pay full taxes on the dividends and cg distributions even though I had barely held the funds for 2 months.

  4. bill says:

    In reference to the above about capital gains and dividends, do they have an ex-dividend date and ex-capital gains date on mutual funds? I know on stock they have and ex-dividend date. Can someone clarify this?

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