Capital Gains Distribution (Managed Funds) – Definition

Cite this article as:"Capital Gains Distribution (Managed Funds) – Definition," in The Business Professor, updated March 2, 2020, last accessed June 3, 2020, https://thebusinessprofessor.com/lesson/capital-gains-distribution-definition/.

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Capital Gains Distribution Definition

Capital gains distribution refers to an investment payout distributed to investors by the fund’s manager. Capital gains are made of profits realized when securities or stocks in a fund or investment are sold by the manager. Capital gains can also be realized from interest earned by a fund or the fund’s returns minus its operating expenses. According to tax and investment law in the United States, fund managers are mandated to pay a percentage of an investment’s income to investors as capital gains.

A Little More on What is a Capital Gains Distribution

Capital gains distributions are taxable, these are payment from a fund or investment shared amongst shareholders. The most common sources of capital gains are profits realized over the sale of stocks and securities and interests (returns) realized by an investment.

Capital gains are distributed to investors based on the number of stock holdings they have in the investment. This means investor A might get more distribution than investor B if the former has a greater holding. Capital gains distributions are done by fund managers and are subjected to capital gains tax by the Internal Revenue Service (IRS).

Capital Gains Distribution Instance

The same way capital gains distributions is mandatory for a fund manager is the same way shareholders are mandated to pay capital gains tax. Capital gains are often distributed using the number of holdings an investor has in a fund. Also, the distribution is based on how long the fund held the holdings that were eventually sold.

The long-term capital gains and are short-term capital gains are also considered in the distribution of capital gains.

Generally, capital gains distributions are done at that period of the year then the investment is no longer yielding returns and or less profitable.

The length of time at which an investor holds or owns stocks in a fund is not considered in capital gains tax, essentially, the fund itself and how long it holds the stocks sold is important. Hence, whether an investor holds stocks in a fund for only three months, such an investor is still required to pay long-term and short-term capital gains tax using the duration the fund held the stocks.

Capital Gains Distributions and Net Asset Value

A capital gains distribution has an effect on the Net Asset Value (NAV) of a mutual fund. The number of profits distributed to shareholders as capital gains are deducted from the NAV of a fund. For instance, if the NAV of a fund is $100 and $20 was shared to investors as capital gains, this would be deducted from the NAV giving an $80 remainder.

Reference for “Capital Gains Distribution”

https://www.investopedia.com/terms/c/capitalgainsdistribution.asp

https://www.thebalance.com › Investing › Mutual Funds › Taxation

https://investinganswers.com/financial-dictionary/…/capital-gains-distribution-1027

www.businessdictionary.com/definition/capital-gains-distribution.html

lexicon.ft.com/Term?term=capital-gains-distribution

Academics research on “Capital Gains Distribution”

Open-end mutual funds and capital-gains taxes, Barclay, M. J., Pearson, N. D., & Weisbach, M. S. (1998). Open-end mutual funds and capital-gains taxes. Journal of Financial Economics49(1), 3-43. Despite the fact that taxable investors would prefer to defer the realization of capital gains indefinitely, most open-end mutual funds regularly realize and distribute a large portion of their gains. We present a model in which unrealized gains in the fund’s portfolio increase expected future taxable distributions, and thus increase the present value of a new investor’s tax liability. In equilibrium, managers interested in attracting new investors pass through taxable capital gains to reduce the overhang of unrealized gains. This model contains a number of empirical predictions that are consistent with data on actual fund overhangs.

Market valuation of tax‐timing options: Evidence from capital gains distributions, Chay, J. B., Choi, D., & Pontiff, J. (2006). Market valuation of taxtiming options: Evidence from capital gains distributions. The Journal of Finance61(2), 837-865. We examine a distribution that is taxed as a capital gain rather than as a dividend. Since the distribution induces a realized capital gain while the price change is an unrealized gain, ex‐day return behavior provides evidence of the value of tax‐timing capital gains. We show that investors are compensated 7¢ in unrealized gains for each dollar of realized capital gains, that is, $1 of realized capital gains is equivalent to 93¢ of unrealized gains. An investor with a tax rate on realized gains of 15% has an effective tax rate on unrealized capital gains of 8.6%.

Risk, the pricing of capital assets, and the evaluation of investment portfolios: Comment, Mains, N. E. (1977). Risk, the pricing of capital assets, and the evaluation of investment portfolios: Comment. The Journal of Business50(3), 371-384.

Taxes and mutual fund inflows around distribution dates, Johnson, W. T., & Poterba, J. M. (2008). Taxes and mutual fund inflows around distribution dates (No. w13884). National Bureau of Economic Research. Capital gain distributions by mutual funds generate tax liability for taxable shareholders, thereby reducing their after-tax returns. Taxable investors who are considering purchasing fund shares around distribution dates have an incentive to delay their purchase until after the distribution, since this will reduce the present value of their tax liability. Non-taxable shareholders, such as those who invest through IRAs and other tax-deferred accounts, face no such incentive for delaying purchase. This paper compares daily shareholder transactions by taxable and non-taxable investors in the mutual funds of a single no-load fund complex around distribution dates. Gross inflows to taxable accounts are significantly lower in the weeks preceding distribution dates than in the weeks following them, but gross inflows to tax-deferred accounts do not change around these dates. This finding suggests that some taxable shareholders time their purchase of mutual fund shares to avoid the tax acceleration associated with distributions. Taxable shareholders who purchase shares just before distribution dates also have shorter holding periods, on average, than those who buy after a distribution. The cost of the distribution-related tax acceleration for pre-distribution buyers is therefore somewhat less than that for those who buy after the distribution.

The effect of taxes on shareholder inflows around mutual fund distribution dates, Johnson, W. T., & Poterba, J. M. (2016). The effect of taxes on shareholder inflows around mutual fund distribution dates. Research in Economics70(1), 7-19. Taxable investors who are considering purchasing mutual fund shares around the dates when a mutual fund is planning a taxable distribution can reduce the present discounted value of their tax liability by delaying their purchase until after the distribution date. Non-taxable shareholders, such as those who invest through IRAs and other tax-deferred accounts, face no such incentive for delaying a purchase of the fund. This paper compares daily shareholder transactions by taxable and non-taxable investors in the mutual funds of a single no-load fund complex around distribution dates. Gross inflows to taxable accounts are significantly lower in the weeks preceding distribution dates than in the weeks following them, but gross inflows to tax-deferred accounts do not change around these dates. This finding suggests that some taxable shareholders time their purchase of mutual fund shares to avoid the tax acceleration associated with distributions. Taxable shareholders who purchase shares just before distribution dates also have shorter holding periods, on average, than those who buy just after a distribution. Since the cost of the distribution-related tax acceleration for pre-distribution buyers is related to the expected holding period of the shares, this finding provides some evidence of clientele formation among the buyers of mutual fund shares.

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