Year-end fund distributions can cause needless worry
Merry Christmas. I hope all of you enjoy a wonderful holiday.
There isn’t much new information to write about today. The market is kind of in a holding pattern that is fairly typical for this time of year. If I had to make a prediction, I’d say stocks will have an upward bias in the shortened holiday trading week after Christmas, but after the New Year, all bets are off. There really is no fundamental or technical reason for a major correction, but in two of the past three years stocks have plunged in January. So I would urge investors to be cautious and be ready for a quick exit if stocks turn down sharply in the next few weeks.
There is one other topic I should cover briefly. If you are holding mutual fund positions, in the past few days or couple of weeks you might have been surprised by a sharp drop in the price or NAV of some of those funds. It could have been a pretty dramatic drop of even 10% or more in a single day. But while the price of the fund showed a dramatic drop, the account value did not decline. That is because of a phantom distribution that takes place with most mutual funds during December.
The distribution results from dividends paid to the fund by the stocks that it owns during the year. For accounting purposes, this distribution of dividends shows up as investment income paid to you. (And that is how the IRS views it if your mutual funds are not held in a qualified account like an IRA.) In reality, the distribution is calculated into the NAV of the fund and you simply end up owning more shares at a lower price. The account value never changes.
Let’s say you own 10 shares of XYZ Fund and on December 18, those shares were valued at $10 each. During the year, the fund accumulated dividends, yields and distributions equal to 10% of the fund’s total value. In reality, this stock income has been included in the price of the fund all year long. But on December 19, the fund passes these earnings on to you as a phantom distribution. So while your account value on December 19 is the same total of $100 as it was on December 18, instead of owning 10 shares valued at $10 each you now own 11 shares valued at $9.09 each.
You can see an illustration on the chart below. This is Wells Fargo Mid-Cap Disciplined Fund (SMCDX). It is up more than 18% this year, but the chart makes it appear as though the fund suffered a significant price drop a few days ago. In reality that was a distribution and the charting company will eventually figure that out and fix the problem.
If you haven’t seen this occur with a fund you are holding, you still might before the end of the year. When it does, now you will know what is happening and not panic when it appears that fund performance takes a major one-day plunge.
Have a great holiday.
F.S.