Bill Nygren’s market commentary for the fourth quarter 2014.
“It’s one of the most frustrating aspects of mutual fund investing: paying capital gains taxes when you haven’t sold a single share.”
-Beverly Goodman, Barron’s December 13, 2014 “Fund Investors Get Hit With Surprising Capital Gains”
Like much of the mutual fund industry, our Oakmark Funds had higher than normal capital gains distributions in 2014. Going into year six of the market advance, there just weren’t many losses left to offset the gains realized on stocks we sold. The Oakmark Select Fund, with a distribution of 12% of its value, unfortunately made some lists of tax-unfriendly funds due to its double-digit distribution. Oakmark Select’s 2014 performance benefited from three mergers: DirecTV being acquired by AT&T, Forest Laboratories by Actavis and TRW Automotive Holdings by ZF Friedrichshafen. A year ago those three acquirees accounted for 18% of the Oakmark Select portfolio, and their sales accounted for the majority of our gains. Unless we wanted to hold stock in the acquiring companies, there simply wasn’t a good way to avoid recognizing those taxable gains. But given the disconnect between our large distributions this year and our claims to be a tax-sensitive fund family, an explanation might be helpful.
Mutual funds are one of the only securities that require owners to pay capital gains before they sell their shares. Every mutual fund annually has to total up the capital gains it realized during the year and distribute the net gain proportionately to its shareholders. The shareholders are taxed currently on that gain despite not selling their shares. When a shareholder does eventually sell, the gain on sale is reduced by the amount of the gains recognized each year that the shares were held. In the end, capital gains taxes are paid on the exact amount of the total gain, but some of that gain was “prepaid” via the annual taxable distributions.
Bill Nygren: Mutual funds present a great opportunity
As an aside, I believe mutual funds present a great opportunity for tax simplification. Given that many investors now have a short-term outlook (most Oakmark investors aside, thankfully), the value to the government of the “prepayment” is trivial relative to the record-keeping costs it generates. Taxing fund shareholders only when they sell shares would cost the government next to nothing, reduce administrative expenses and encourage fund investors to improve their own performance by reducing their turnover. But alas, for now the rules are what they are.
At Oakmark our goals are to maximize long-term returns and—more specifically—to take every reasonable opportunity to maximize after-tax returns when those actions don’t harm our tax-free shareholders. Some funds that claim to be “tax-efficient” focus so much on minimizing taxes that they also inadvertently reduce their returns. We want to minimize the hole in the donut that is lost to taxes, but do so without reducing the size of the donut.
Bill Nygren: Reducing shareholders’ tax burden
One of the most obvious ways we reduce shareholders’ tax burden is by using our long-term approach, which typically produces long-term gains. For most individuals long-term capital gains are taxed at less than half the rate paid on short-term gains. Based on distributions paid last year, over 20% of the average mutual fund capital gain distribution was short-term gain. The Oakmark Fund has paid out nearly $15 per share in gains since 2000. Of that, only $0.08 was short-term gain, about half of one percent. Since its inception in 1996, Oakmark Select has distributed $0.56 of short-term gain, a little over 2% of total gains. When our stocks appreciate quickly and hit sell targets before we’ve held them for a full year, unless we see unusually high risk in continuing to hold, we will generally wait to sell until our holding period exceeds one year so that we get the less expensive long-term gain rate. You might wonder why our Global Select Fund would keep such a small position in Medtronic. The answer is that we have a nice gain in those shares and that they have not yet turned long-term.
In some cases when a company gets a stock acquisition offer—as one of our holdings, Forest Laboratories, did earlier this year—we protect the gain while we wait for shares to turn long-term by selling shares of the acquirer short. Mutual funds generally don’t engage in short sales because they are perceived to be higher risk, but in this case, we believe the short sale both reduces taxes and risk.
Bill Nygren: Capturing tax losses
We also capture tax losses to net against our gains. We look at our holdings by tax lot and will routinely sell any individual tax lot that has a loss of 20% or more. Many value funds don’t take this step because value investors typically believe stocks that have gone down in price have become more attractive. Though we often agree, when we have a loss to capture, we will either sell some shares immediately and repurchase in 31 days (to avoid wash sales rules) or buy more immediately and sell those shares in 31 days. We do this throughout the year, which allows us to maintain our core positions in the stocks we believe are most attractive while still capturing losses and reducing our net gain. Further, we believe this benefit to our taxable shareholders has been achieved without harming our tax-free holders. So when you see our portfolio turnover spike, as when the Oakmark Fund’s hit 62% in the 2009 turmoil, check to see if we might be engaging in tax-loss selling before you conclude we’ve abandoned our long-term approach.
Another way we seek to capture losses is to replace losing stocks with similar, but equally attractive, stocks. An example in the Oakmark Fund from this past quarter was selling our remaining Cenovus shares and redeploying the proceeds into Chesapeake. We believe Cenovus is a fine, well-managed company, but due to rapidly declining oil prices, it had fallen beneath our purchase price. Another company we believed was also fine and well-managed, Chesapeake, had fallen to a price where it appeared to us to be more attractive than Cenovus. So even though Cenovus was far beneath our sell target, we captured the loss, increased our exposure to an energy sector we thought was cheap and switched to a stock we believed was somewhat more attractive.
Bill Nygren: Investing in cheap stocks
When Kevin Grant and I started managing the Oakmark Fund in 2000, we inherited a portfolio full of cheap stocks that had been left behind in the Internet boom. Because the Fund had suffered heavy redemptions, the portfolio had fewer positions in it than we thought was appropriate, especially given how many other stocks were also priced inexpensively. So we sold the high-cost tax lots from each position and reinvested in other cheap stocks. The resulting capital loss carry forward allowed us to fully shelter our gains until a distribution was finally required in 2006.
Making sure almost all of our gains are long-term before we realize them actually reduces the total amount of tax our shareholders pay. The other steps—tax trading around a core position, swapping loss positions into stocks with similar exposures, as well as transactions involving short sales, stock options, merger arbitrage and exchanges of similar securities—simply delay the