• 97% of equity and fixed income mutual funds have posted losses this year and 60% of active mutual managers are underperforming their benchmark
• Despite these losses, history shows that mutual funds may still pay out capital gains – reducing investors’ after-tax return
• Investors can tax-loss harvest now to avoid potential cap gains distributions and reposition portfolios with more tax-efficient ETFs¹
  

The pain of poor absolute investment returns extends across mutual funds, ETFs, and separately managed accounts. But it could get worse for mutual fund investors this fall when mutual funds begin releasing information on capital gains dividends to be paid out prior to yearend.

Cap gain dividends result from mutual funds incurring gains during the year on investment transactions. You might think that with markets down significantly, there would not be any gains to pay out. Unfortunately, history shows that funds pay out capital gains dividends even when markets are down. And that means additional taxes for the funds’ shareholders.

Consider tax-loss harvesting now to avoid potential cap gains distributions and reposition portfolios with more tax-efficient ETFs.²

How Broad Are Mutual Fund Losses?

As of the end of July, 97% of all mutual funds, active and passive, had negative returns. The losses were slightly more plentiful in fixed income, given how rates have risen and credit spreads have widened in 2022. So far, 99% of fixed income mutual funds have losses, compared to 96% of equity funds.³

Dating back to 2001, this is the worst year for performance — even worse than during the Great Financial Crisis in 2008. While year to date equity returns are not worse than 2008’s, the current significant weakness in fixed income pushes the total number of funds with losses in 2022 29 percentage points higher than in 2008.

As of the end of July, 60% of active mutual fund managers have underperformed their stated benchmark. This is the highest underperformance rate since 2018 — and higher than the 53% historical average of managers underperforming dating back to 2001. And similar to the absolute returns shown above, fixed income strategies have had the weaker results. Nearly 70% of all active fixed income managers have underperformed their benchmark so far this year, well above the historical average of 57%.⁴

How Many Mutual Funds Might Distribute Cap Gains This Year?

There have been global equity losses in seven of the past 21 years.⁵ In the more recent downturns in 2018, 2015, and 2011, the fund industry was more diverse than it was in the dot-com and Great Financial Crisis eras. For example, in 2008 there were 3,000 funds, but now there are more 5,400.⁶

In each of those three years, the percentage of mutual funds paying capital gains – active, passive, and across asset classes – was greater than the historical average, as shown below. Examining those three years and 2020, which also featured a brief bear market, along with fund flow patterns points to a potentially higher number of mutual funds distributing capital gains this year.

Mutual Fund Outflows Can Increase Cap Gains Distributions

Given mutual funds’ subpar returns come at a higher cost than with ETFs,⁷ it’s no surprise that mutual fund flows have been significantly negative through July. As shown below, active mutual funds have experienced a total of $491 billion in outflows, from both active equity and bond funds. Active ETFs have had inflows, however, as have indexed mutual funds and passive ETFs.  

These substantial outflows from active mutual funds — along with increased trading in a volatile market — increase the likelihood of capital gains distributions this year. That’s because whenever a redemption occurs, mutual funds must sell securities to raise cash, creating capital gains distributions for investors still holding the fund. That is not the case with ETFs. An ETF redemption triggers an in-kind exchange process that usually does not cause a taxable event for investors still in the fund.

In the five years since 2001 when mutual funds have had net outflows, 53% of funds on average paid cap gains, compared to 47% overall. For active mutual funds alone, the average increases to 54% in years with outflows, compared to 48% overall.⁸

Could 2022 Follow 2018?

Because markets nearly fell into a bear market and rates rose in 2018, it seems the most appropriate comparable for 2022. And, as shown earlier, absolute returns were weak in 2018, with greater than 75% of funds posting negative returns. The relative returns for active mutual funds in 2018 were also similar to what we are seeing in 2022; more than 66% of active strategies underperformed their benchmark in 2018.

In 2018, 61% of funds paid cap gains and 69% of active funds paid cap gains. Thirty percent of funds had negative absolute returns, negative relative returns, and a cap gain distribution.⁹ Given 2022’s similarities to 2018, we might expect nearly one-third of today’s active mutual funds to have absolute losses and negative excess return — and distribute capital gains before the year is over.

Tax-Efficient ETFs Generally Don’t Distribute Capital Gains

Exchange traded funds (ETFs) inherent tax efficiency stems from their capacity to effect in-kind creation/redemption transactions and investors’ ability to buy and sell shares on the secondary market and leave the underlying fund unaffected. In fact, so far in 2022 for every $7 traded in ETFs on the secondary market, only $1 has hit the primary market (the fund).¹⁰

Consequently, the percentage of mutual funds paying capital gains dividends in a given calendar year is, on average, 11 times greater than the percentage of ETFs that pay capital gains.

ETFs’ tax efficiency extends across active and passive mandates. While active ETFs pay out more dividends than passive ETFs, they still pay less than half of what active mutual funds pay. Over the past five years, an average of 20% of active ETFs have distributed cap gains, compared to 60% of active mutual funds. The ETF average is somewhat skewed by the fact that in the early years, in 2011 for, there were less than 50 active ETF strategies and now there are more than 900 funds.¹¹

Analyzing distributions by asset class, active equity (52%) and active fixed income (33%) mutual funds have historically had higher cap gain payer percentages than active equity (20%) and active fixed income (24%) ETFs.¹² The differential is more pronounced for passive funds -- 48% for active equity mutual fund active versus to 5% for active equity ETFs and 52% for active bond mutual funds versus 12% for active bond ETFs.¹³

Keeping the Great Migration to ETFs Going

If you own an active mutual fund that is down on the year, underperforming its benchmark, and has historically paid a capital gain, perhaps it’s time to consider cutting your losses before a bad situation gets worse.

Harvesting the loss from your portfolio and swapping into an indexed ETF could lower your portfolio costs and increase its tax-efficiency. And, if you prefer an active ETF, the burgeoning active ETF marketplace has now reached $330 billion with more than 900 strategies to choose from.¹⁴

Bigger picture, if one-third of today’s active mutual funds do indeed have absolute losses, negative excess return, and capital gains distributions this year, that will likely accelerate the trend of investing in ETFs, both active and indexed.