The performance improvement of non-U.S. stocks
(Russell Developed ex-U.S. Large Cap Index and Russell Emerging Markets Index) over the past 12 months ending July 2017 has been a welcome change for many diversified investors. Ever since the U.S. equity market (Russell 3000® Index) hit its lowest point in March 2009 at the end of the Global Financial Crisis (GFC), U.S. stocks outperformed most other major asset classes as of July 2017, often making non-U.S. allocations come into question. However, in the last 12 months that leadership has rotated: U.S. stocks are trailing international and emerging markets stocks.
Source: U.S. stocks—Russell 3000® Index. International Developed Stocks—Russell Developed ex-U.S. Large Cap Index. Emerging Markets Stocks—Russell Emerging Markets Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
Unfortunately, there’s a hitch for globally-diversified taxable investors
: Non-U.S. equity mutual funds may generate higher taxable distributions and lower after-tax returns than expected.
It will be tough for many investors to accept—globally-diversified investors are finally rewarded for their discipline and patience only to have those investment rewards eaten up by taxes? How is that possible?
Five words explain what’s happening: Expiring capital loss carry forwards.
Let’s take a quick walk down memory lane to understand.
The Global Financial Crisis and capital loss carry forwards
Recall that the GFC allowed many investors and mutual funds to recognize sizeable capital losses in 2008 and 2009. After all, the Russell Global ex-U.S. Index was down -61% from October 11, 2007 through March 9, 2009. As painful as those losses were at the time, from a tax perspective, they had a benefit: These recognized capital losses could be “carried forward” and used to offset future recognized gains. For taxable investors, this ability to offset gains with losses can be very powerful way to help manage their tax bill and potentially improve their after-tax returns.
For instance, the table below shows how capital loss carry forwards (CLCF) have helped many non-U.S. equity mutual fund investors lose less of their return to taxes (lower tax drag) than U.S. equity mutual funds in the five years ending April 2017. The average U.S. equity fund investor lost 1.51% of their return to federal taxes—each year. The comparatively lower tax drag for non-U.S. equity mutual funds (0.90% for Non-U.S. developed equity) reflects lower returns and CLCF’s to offset the modest gains.
Source: Tax drag = Morningstar tax cost ratio.
||Tax drag/Return lost to taxes for the five years ending April 2017
|Non-U.S. developed equity
|Emerging markets equity
The bad news is that the last of the CLCFs recognized during the GFC are set to expire this year. A change to the U.S. tax law in 2010 mandates that capital losses that were recognized prior to 2010 expire eight years after recognition. That means the losses that were harvested in 2009 will expire this year—just as returns for many of these Funds are improving… leaving many globally-diversified investors hanging. A key point to recognize for globally diversified investors today is that many non-U.S. equity mutual funds still have quite sizeable capital loss carryforwards on their balance sheet, since they didn’t need to dip into them much in the years since the GFC (remember the relatively modest returns of many non-U.S. equity mutual funds vs. U.S. equity funds in the post-GFC years). So, those accumulated CLCFs can help offset the stronger returns experienced by many non-U.S. equity mutual funds in the past 12 months.Globally-diversified investors today
Source: Non-U.S. Stocks: Russell Global ex-U.S. Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.
How can you help your globally-diversified clients?
Step 1: Determine whether your client’s investments might be affected.
This will require a bit of digging.
Step 2: Consider moving affected investors, as appropriate, to mutual funds that are intentionally tax-managed.
- For each mutual fund your client holds, research how much CLCF is expiring and when. Typically, a mutual 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.
In the hypothetical example above, the Core International Fund has $112.250 million expiring in 2017 and another $25 million expiring in 2018.
- 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 use up the CLCF.
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 considering discussing these sorts of portfolio changes with your affected clients. Delaying the decision may cause an additional and avoidable taxable event. Depending on the client’s circumstances, incorporating 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 into a tax-managed approach
The bottom line
While there is cause for celebrating the improvement in non-U.S. equity returns in the past 12 months ending July 2017, this may lead to higher taxable distributions for some globally-diversified investors: Odds are high that a material portion of many non-U.S. equity mutual funds’ capital loss carry forwards are expiring this year—if they haven’t already. However, a tax-smart investment approach can help soften the tax drag.