Driving in Massachusetts can be confusing. South Boston, for example, is actually east of the city, while East Boston is to the north. And the road labels can be just as bad. There is a section of a major highway, where two roads converge, where you can actually be headed south on one highway and north on another at the same time.
Hard to believe—and even harder to describe when you try to give directions—but true. Don’t try this if you’re not from around here.
Navigating mutual fund results
Mutual fund gains and losses can create similar confusion. For example, how can a fund make taxable distributions of profits from specific share investments at the same time that the fund itself is down for the year? Isn’t this like heading south and north at the same time on the same road?
Not exactly, but to understand why, we have to go back to how mutual funds work. Essentially, a mutual fund is a collection of investments in different stocks or bonds, bought and sold at different times as the manager decides, all for the benefit of individual shareholders, who own a piece of the entire portfolio.
The way this plays out for those shareholders depends on the results of individual companies the fund invests in, but those results will differ from the results of the fund as a whole. In exactly the same way, the buy and sell dates of the shares the fund owns will differ from the performance dates the fund reports. It is indeed possible for a stock to have headed north at the same time a fund has gone south.
Here’s an example
Suppose a mutual fund owns only one stock, of company ABC. It buys a share at $100 on January 1, 2000. Because the fund managers are good analysts, they buy right, and the stock soars to $150 on December 31, 2000. Both the stock and the fund are up.
Then, in 2001, the stock drops to $125; at the end of the year, the fund managers decide to sell at $125. For 2001, the fund’s shareholders would see the following:
- First, the sale of the stock would trigger a taxable distribution on the $25 gain.
- Second, the fund itself would lose money for the year, as its single holding declined in price from $150 at the start of the year to $125 at the end.
So, the fund ends up heading south while the stock itself, over the holding period if not the past year, heads north. In real mutual funds, of course, the dynamics are more complicated, but the underlying process is the same. The results of individual investments over different holding periods can be substantially different from that of the fund itself over a time period.
Just think of it as a slight tax detour
Although it can be frustrating to see both a tax bill and a loss on an investment, look at it this way: the tax bill has come later than it might have. You enjoyed the gain in a previous year in that fund but haven’t had to pay taxes on it until just now.
Like many investment facts, this sort of result appears counterintuitive until you look at the underlying reasons—and then it makes perfect sense. Unlike, of course, the roads in Massachusetts, for which I’ve yet to find a good explanation.
Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.