Beware the lurking tax hit in many non-U.S. equity funds

A change in the 2010 tax code may have a material impact on after-tax returns in coming years. Non-U.S. equity funds may feel the pinch the hardest. Make sure to position your clients’ portfolios before it’s too late. A quick primer: The Global Financial Crisis and Capital Loss Carry Forwards (CLCFs) We all remember the Global Financial Crisis, when global stocks dropped -42% for the calendar year 2008, according to the MSCI All Country World Index. But it wasn’t all bad news for many mutual fund investors. Here’s why: While mutual funds are required to distribute realized gains to shareholders, they do not distribute realized losses. If the realized losses are bigger than gains in a given year, mutual funds are able to carry them forward into future years to be used to offset against future gains. This tax offset is called Capital Loss Carry Forward (CLCF). CLCFs since 2008 For the past eight years, investors in funds with CLCFs have benefited from the CLCFs in two primary ways:
  • Reduced capital gains tax bills – because many mutual funds have used their CLCFs to offset gains coming out of 2008
  • Improved after-tax returns.
U.S. equity mutual funds and CLCFs Over the years, the strong U.S. equity market gains since 2008 have caused many U.S. mutual funds to deplete their CLCF reserves. As a result, investors in many cases have seen an increase in taxable distributions – as depicted in the exhibit below – and a reduction in after-tax returns. Source: ICI 2016 Factbook Source: ICI 2016 Factbook According to Morningstar, as a whole, U.S. equity funds (active, passive, ETFs) gave up 2% of returns for the three-year period ending June 2016 to taxes – that’s twice as much as the 10-year average of just over 1% of returns given up to taxes. For example, a mutual fund with a 10% pre-tax, three-year annualized return actually had a return of only 8% on an after-tax basis. This loss of return (“tax drag”) of 2% is really a hidden expense ratio that can have a material impact on an investor’s ability to reach their desired outcomes. Too many investors fail to consider the tax drag as a factor when evaluating taxable investment options.   Non-U.S. equity mutual funds and CLCFs It’s a different story for many non-U.S. equity funds. For the past five years ending July 2016, non-U.S. equity markets have trailed U.S. equity markets by quite a wide margin. Source: U.S. equities – S&P 500 Index. Non-U.S. equities – Russell Global ex-U.S. Index. Past performance is no guarantee of future results. Indexes are not managed and cannot be invested in directly. Source: U.S. equities – S&P 500 Index. Non-U.S. equities – Russell Global ex-U.S. Index.
Past performance is no guarantee of future results. Indexes are not managed and cannot be invested in directly. As a result, many non-U.S. equity funds still have CLCFs that they’d built up in 2008/2009 in reserve today. Taken together, the lower market returns and larger CLCFs for many non-U.S. equity funds (both International and Emerging) have amounted to non-U.S. equity mutual funds as a whole losing only 0.95% to taxes for the three years ending June 2016. Tax drag Morningstar: Tax Cost Ratio, Russell Investments: average Changes to tax treatment of CLCFs: implications for mutual funds Unfortunately, a substantial portion of the CLCFs many international equity funds have accrued may soon be expiring without funds being able to use them up – because of a tax code change made in 2010. The Regulated Investment Company Modernization Act of 2010 changed the tax rules so that any CLCF that occurred in taxable years before December 22, 2010 expire eight years after occurrence while CLCFs that occurred after December 22, 2010 can be carried forward indefinitely. The challenge is, many of the CLCFs mutual funds have on their balance sheets were created during the Great Financial Crisis in 2008 and 2009. So, under the 2010 Act, they are set to expire in 2016 and 2017. To make matters worse, the CLCFs accrued after the new tax rule was enacted must be used before a fund can use CLCFs banked before the rule was enacted. This further increases the odds of these pre-enactment CLCF’s expiring. Many funds could well be losing a valuable tax offset from their balance sheets. If non-U.S. equities see modest returns closer to their long term average, the amount of capital gains distributed to investors will likely increase and the amount of after-tax return investors receive will decrease. How can advisors help clients who may be affected? Step 1: Determine whether or not your clients might be affected. This will require a bit of digging.
  1. Typically, a fund will publish a schedule of its CLCFs in their annual Statement of Additional Information. Below is an example of how the data may be presented. expiring-capital-loss-sm
  2. For each fund your clients hold, note how much CLCF is expiring and when. In the hypothetical example above, the Core International Fund has $20 million of CLCF expiring in fiscal year 2016, $113.7 million expiring in 2017 and another $25 million expiring in 2018.
  3. Measure the materiality of the expiring CLCF by comparing its size to that of the overall mutual fund. If the expiring CLCF represents a small percentage of the fund’s total AUM, it would only take modest positive market returns to eat through the CLCF.
Step 2: Consider moving affected investors, as appropriate, to funds that are tax-managed by design. If the mutual fund’s investment objective mentions tax management, it opens up the toolkit the fund can use in an attempt to dial down tax drag and maximize after-tax return. Step 3: Don’t delay. Don’t wait until after the CLCFs expire before making this investment change. Delaying the decision may cause an additional and avoidable taxable event. Starting a tax-managed international equity approach before the CLCFs expire may lessen any related tax hit on appreciation of shares from now until the point when you decide to make a tax-managed move. You could also consider having clients invest new dollars and reinvest future distributions immediately in a tax-managed approach.

The bottom line

Investing beyond U.S. borders has the potential to improve returns and offer attractive diversification benefits, although diversification doesn’t protect against a loss. To further help reap the rewards of the potential return benefit of non-U.S. investment opportunities, it makes sense to take tax considerations into account in that part of your clients’ portfolios, too. This is truer than ever right now, when many non-U.S. funds may soon be losing the tax benefit of CLCFs.
Disclosures: Tax drag calculation methodology:
  • All U.S. equity and non-U.S. equity investment products, including ETF’s, as reported by Morningstar Direct. • When a fund had multiple share classes, took the share class with the largest AUM. This prevented a fund being counted more than once. • Calculated arithmetic average for:
o Pre-tax return o After-tax return (pre-liquidation) o Tax drag (Pre-tax less after-tax return) These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. This material is not an offer, solicitation or recommendation to purchase any security. Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. MSCI All Country World Index: captures large and mid cap representation across 23 Developed Markets and 23 Emerging Markets countries. With 2,481 constituents, the index covers approximately 85% of the global investable equity opportunity set. S&P 500 Index: An index, with dividends reinvested, of 500 issues representative of leading companies in the U.S. large cap securities market. Russell Global ex-U.S. Index: measures the performance of the global equity market based on all investable equity securities except those in the U.S. All securities in the Russell Global Index are classified according to size, region, country, and sector, as a result the Index can be segmented into thousands of distinct benchmarks. Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management. Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand. The Russell logo is a trademark and service mark of Russell Investments. Copyright © Russell Investments 2016. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty. Russell Investments Financial Services, LLC, member FINRA (, part of Russell Investments. RFS: 17767