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Mutual Fund Sell Downs And Other Unintended Consequenses For Investors:

What Is A Mutual Fund Sell Down?:

The general public, in addition to many advisors, do not know what a forced sell down of a mutual fund is.  A forced sell down by a mutual fund often times occurs when financial markets sell off.  As a result, the mutual fund could may have to liquidate underlying holdings in order to meet redemption requests.  A classic example of a forced sell down was during the market downturn of the fall of 2007 through the spring of 2009.  Many mutual funds were forced to sell securities with underlying gains because of the panic in the markets at that time.  While this is an extreme example, this can happen any time that a particular asset class is going through a rough patch.  Examples include: 2000 to 2002, 1987, and 1972 to1974. 

Potential Income Tax Problems:

One of the problems during a forced sell down is that a mutual fund could be liquidating securities with large capital gain positions because those positions are the most liquid.  Assume that in 2007 and the very early part of 2008 that a large stock growth fund gained 40.0%.  Often times, most of that gain won’t be taxed until at least the following year because the position would not be sold; therefore, the gain would stay as unrealized.  During this time, the public was panicking and in order to meet redemptions for cash, the portfolio manager was forced to liquidate securities that had large capital gains in order to obtain cash to meet redemption requests.   Therefore, some of those positions with large gains had to be sold.  For that year then, the mutual fund had a realized capital gain (from a position that normally would not have been sold) that had to be distributed to the shareholders, even though some of those remaining shareholders may have just recently invested in the fund.  This, obviously, was a negative consequence for the remaining shareholders who stayed in the fund through the end of that year due to a forced sell down.  To make matters worse, a investors who had recently purchased the fund (later in the year) would have to sell their position to avoid the taxable distribution.  This caused more sales and correspondingly more gains to be distributed to the remaining shareholders who were holding on. 

More Problems:

A forced sell down is not the only situation that can push an investor into trouble with regard to capital gain distributions.  What if a fund already recognized capital gains earlier in the year, but the fund’s returns are negative for the rest of the year?  The fund, due to its income tax circumstances, may still have to pay out distributions that are taxable to the investor even though they had an economic loss.

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