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As we wait to see what form the tax legislation takes as it makes its way through Congress, we’ve been getting questions about how it will affect individual taxes and what steps people should take now to minimize any negative impact it may have on them.  The answer is it depends on what version makes it through, as some of the tax-savings ideas I’ve read over the past few weeks – such as paying your real estate taxes for 2018 now to avoid the proposed $10,000 property tax limit – may be shut down by parts of the legislation.  We’ve been keeping up, and promise to provide you with a summary of how it will likely affect you as soon as it becomes final.

In the meantime, I wanted to address another question we’ve gotten this year, and just about every year around this time:  Why did my portfolio go down in value so much today?

Last Friday, the Dow Jones Industrial average was up 140 points.  After the market close, a client contacted us who said he logged into Fidelity looking forward to seeing a jump in the value of his portfolio, but instead his accounts were down $77,000 and he was quite shocked.  He is not the first person!

The good news is his portfolio wasn’t actually down, but only appeared to be, due to a timing phenomenon that occurs every quarter when dividends and interest distributions are paid from mutual funds.   Most quarters people don’t even notice, but in December the effect is much more pronounced due to annual capital gain distributions.  Understanding what’s happening might help ally your concerns.

Mutual funds are required to pay net income and net realized capital gains to their shareholders at least annually to avoid being taxed as a separate entity.  Most distribute interest from bonds and dividends received from stocks on a quarterly basis.  During the year fund managers are also selling stocks and bonds held inside the funds, preferably at a profit, incurring capital gains.  These gains are accounted for and distributed in December each year to avoid the high cost alternative of multiple transactions.  In a year like 2017 where every asset class is posting significantly positive returns, the capital gains from sales can be significant, leading to a larger year-end distribution.

The share price of a mutual fund is made up of the cumulative value of all the holdings in the fund, known as the Net Asset Value or NAV.  When a mutual fund pays a dividend, the NAV of the fund drops afterwards by the amount of the dividend paid.  In December the distribution, and resulting share price drop, includes the capital gain distributions that are passed through as well.

After the distribution is complete, and the NAV of the fund goes down by the amount of distribution paid out, the drop in the fund value is offset by the deposit of cash into your brokerage account for all the dividends, interest and capital gain distributions received.  But there is a timing difference.

Both Fidelity and Schwab, the custodians we use to hold our client accounts, sweep the deposits into your money market fund where it earns interest and is available for distributions to you, or reinvestment in other asset classes in your portfolio.  There is a one-day lag as all the incoming deposits are moved from cash and used to purchase shares in the money market fund in the account.  You can still see the cash before it is swept into your money market fund, but it doesn’t immediately appear in your portfolio value total, as the ‘cash’ total must be added to the ‘holdings’ value to reflect the entire portfolio value.

Despite this one point of confusion, mutual funds are excellent tools for portfolio construction:

  • They provide diversification to protect you from drops in individual securities and asset classes.
  • They allow you to hold thousands of companies at a very low cost, something that would be cost-prohibitive to do on your own.
  • The DFA funds in particular allow you to benefit from portfolio lending, price negotiation on trades, and other techniques that enhance your returns.

There are additional capital gain and dividend distributions going out this week, so you’ll see continued impact on your portfolio in the short-term, but now that you know what’s happening, I hope you’ll be less concerned.