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Case Studies in Finance |
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Most everyone is aware that mutual funds are an ideal investment vehicle for the small investor. Mutual funds allow for the benefits of a diversified portfolio yet require only a small amount of funds to be invested. Moreover, for those who wish to avoid market timing strategies and the time consuming process of analyzing individual stocks, index investing in broad market indexes is a favorable alternative. What most people do not know, however, is that even a buy and hold objective pursued through an index mutual fund is not without serious potential tax consequences.
Billy and Sherri Simpson invest regularly in Vanguard's Extended Market Fund, a mid-cap, buy and hold index mutual fund roughly tracking the Wilshire 4500. To date, Billy and Sherri have never withdrawn money from the fund. Instead, they periodically make deposits whenever they have enough to do so. Even though the Simpsons have never sold their mutual fund shares, they noticed on their FORM 1099-DIV, that they were listed as earning $1,266.90 in capital gains (Box 2a).
Thinking there had been a mistake, Billy called Vanguard's 1-800 number and asked for clarification. The Vanguard representative explained that when common stock is owned directly, there are two ways to realize returns: (1) payment of dividends by the company, and (2) capital gains (or losses) when the individual sells their shares. However, with mutual funds, there are three ways to realize a return. The first two are the same as if the stock was owned directly. The third is a capital gain that occurs when the fund itself sells shares in the portfolio. It was this third reason that had caused the Simpsons to realize the capital gain even though they themselves had never redeemed any mutual fund shares.
The next year when the Simpsons received their FORM 1099-Div, they noticed that the capital gains number in Box 2a had jumped up to $4,208.71 even though they did not contribute any more money that year. Knowing that the index fund had a buy and hold strategy, the Simpsons were very surprised that so much turnover could have been caused within a single year's time.
After again calling Vanguard, they learned that due to the stock market's run up in that year, the mid-cap stocks that the fund held were now large cap stocks. To keep to the objective of holding mid-cap stocks, Vanguard said they sold off the firms that had become large cap stocks and used the proceeds to buy smaller firms. This turnover generated realized capital gains that had to be spread out over the mutual fund investment base on a pro rata basis.
The next year, the stock market bottomed out. Vanguard's Extended Market fund lost over 40% of its value. Sherri joked that the good news was that at least they didn't have to pay high capital gains this year. However, at the end of January when they received their FORM 1099-DIV, they saw the highest number yet in Box 2a. The Total Capital Gain Distributions were reported to $7,444.72, even though the Simpsons had never withdrawn money from the account.
Not surprisingly, Sherri called Vanguard for an answer. The Vanguard representative explained that investors panicked when the stock market dropped. They sold off so many shares that the cash the fund keeps on hand to handle "normal" transactions had run out. In order to meet investor demand to withdraw funds, Vanguard had to sell off shares to raise the necessary funds. Many of the shares sold were originally purchased many decades ago. As such, they had a very low cost basis for tax accounting purposes.
Extremely upset by the turn about of events that had transpired, Billy and Sherri Simpson seriously contemplated the way they would invest in the future.
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