Potential capital gain exposure is the percentage of a fund’s total assets that represent capital appreciation. In other words, this is how much of the fund’s assets would be subject to taxation if the fund were to liquidate today.
Where a negative number appears, the fund has reported losses on its books. We cannot predict what a fund’s taxable distributions might be, but we can offer some clues based on a fund’s liquidation liability.
Benefits
Although funds rarely liquidate their entire portfolio, a fund with a higher potential capital gain exposure may be more likely to realize large capital gains in a manager change or strategy shift. A high capital gain exposure often accompanies a low turnover strategy, wherein a fund holds stocks over the long term, allowing profits to accumulate.
Origin
The fiscal year end aggregate appreciation is taken from the fund’s annual report (in the section entitled “Statement of Assets and Liabilities”). To keep our calculation current, we update the information between shareholder reports by accounting for a fund’s market losses or gains, the sale or redemption of shares, and the payment of capital gains. The updates are made with the net assets, capital gains, and share prices that are provided by the fund company. This data point is re-calculated on a monthly basis. The updated figure is not quite as precise as the one stated in the shareholder report, but it is more current and therefore more relevant to the investor.
Example
If a fund has a PCGE figure of 35%, it might initially look like a warning of impending taxable distributions; however, the fund may be pursuing a buy-and-hold strategy as evidenced by a low turnover ratio. Unless the fund has a drastic change of heart about its investment strategy, that 35% will likely remain unrealized in the future, meaning that the fund will probably not have many taxable distributions for which shareholders foot the bill.
If a fund has negative capital gain exposure, this indicates that the fund may have built up a tax-loss carry-forward, which it can use to offset future realized capital gains. Thus, investors should expect funds with negative capital gain exposure to be highly tax-efficient going forward. Conversely, funds that have built up large potential capital gain exposure have been highly tax-efficient in the past, but at some point--unless it has a very low turnover --it will have to realize those gains and make a distribution. Funds that enjoy large cash inflows generally have very low potential capital gain exposure, while funds that experience large outflows often have very high potential capital gain exposure.
For the Pros
The PCGE Formula
The formula for Potential Capital Gain Exposure (PCGE) demonstrates the percentage of total assets that have appreciated but have not been distributed to shareholders—and therefore, not taxed. This appreciation can be either unrealized or realized. In the first case, the fund’s holdings have increased in value, but the fund has not yet sold these holdings; taxes are not due until the fund does so. Realized net appreciation (commonly called realized gains) represents actual gains achieved by the sale of holdings; taxes must be paid on these realized capital gains when the fund distributes these each year (if it can’t offset them with realized losses). Unrealized appreciation may turn into realized gains at any time, should the fund’s management decide to sell the profitable holdings. Thus, our formula includes unrealized appreciation as part of the potential capital gain exposure.
The formula does not take into account undistributed net income, because it would greatly increase the complexity of the calculation but would have negligible impact on the outcome (funds rarely have much undistributed income).
The formula for potential capital gains exposure is simple:
Net Unrealized Appreciation/Current Assets
The numerator can be broken down into three components. Net Unrealized Appreciation is composed of:
FYE Aggregate Appreciation (unrealized)
+ Recent Appreciation (unrealized or realized)
- Recent Capital Gains (realized)
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FYE Aggregate Appreciation: The total unrealized appreciation (or depreciation) as of the last fiscal year end as reported in the fund’s annual report. This is composed of unrealized appreciation or depreciation plus realized gains or losses.
Recent Appreciation: Any gains (realized or unrealized) between the date of the annual report (the date of the fiscal year end) and the date of the most recent month-end. These gains are measured based on the appreciation of the fund share price, the Net Asset Value per share (NAV); the share price is multiplied by the average number of shares in order to get the gross value of gains at the portfolio level. Because any distribution of capital gains lowers the share price by that amount at the time of the distribution, the capital gains are added back into the value of the End NAV for this calculation.
Recent Appreciation = (End NAV + Total Capital Gains – Begin NAV) x (Avg # Shares)
Where:
Begin Date = the date of the annual report
End Date = the date of the most recent month-end business day
Begin NAV = the NAV from the begin date
End NAV = the NAV from the end date
Total Capital Gains = Sum of any per share capital gain distributions between the begin date and the end date.
Avg # Shares = a geometric average of the number of shares outstanding on the begin date and the end date. The number of shares for each date is calculated by dividing the total net assets by the NAV for each respective date.
Recent Capital Gains: The sum of realized capital gains that have been distributed to shareholders since the date of the annual report. The per share capital gain value is multiplied by the number of shares in order to get the gross value of gains that have been distributed.
Recent Capital Gains = SUM(Capital Gainst) x (# of Sharest)
Where:
t = a date between the Begin Date and the End Date when the fund made a capital gains distribution
Capital Gainst= the per share amount of long- or short-term capital gains that were distributed to shareholders on date t
# of Sharest = this is an estimate of the number of shares outstanding on date t. This is calculated by dividing the month-end total net assets (on the next month-end after the distribution) by the NAV on the reinvestment date for Capital Gainst.
Because the fund's asset base serves as the denominator in this calculation, a change in assets from the sale or redemption of shares can greatly influence a fund's potential capital gain exposure. As a fund's asset base grows, the tax impact of previous gains to shareholders is diminished. Conversely, a shrinking asset base amplifies the tax impact of past performance.
A Closer Look
When investing in a fund with a significant potential capital gain exposure, individuals may want to find out if the fund plans any large distributions. They may wish to examine the tax consequences of such a distribution. For example, if an investor buys one share of Northeast Investors Growth at a month-ending NAV of $29.37, then immediately afterwards receives a December capital gains distribution of $4.46, the investor would have a share of the fund worth $24.91, with an additional $4.46 in cash. That cash, however, in the form of a capital gain, is taxable. Consequently, after paying 15% in capital gains taxes, the investor is left with $3.79 in cash.