Questions and Responses

What is meant by "capital gain reinvestment" versus "dividend" reinvestment"?

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What is meant by mutual fund "capital gain reinvestment" versus "dividend reinvestment"?

from Doris

A: (Lou) Mutual fund capital gain and dividend reinvestment conceptually sounds like a simple concept, but is actually very complicated to explain. Let's start with the basics first. According to the Investment Company Institute, a capital gains distribution is profits distributed to shareholders resulting from the sale of securities held in the fund's portfolio. Dividends are dividend income which is derived from actual dividends from the underlying stocks in a mutual fund, interest income from money market securities or bonds, and these days from short term capital gains distributions as a result of the fund deriving profits from buying and selling securities held for less than one year.

A mutual fund typically gives you two options with regard to what to do with capital gain and dividend distributions. You can either reinvest them or you can have them paid to cash. Most individuals choose to have them reinvested. When you reinvest the cash from the fund (the money is actually kept at the fund for convenience) it is reinvested at the Net Asset Value (NAV- The per-share value of a mutual fund). For example if you receive $200.00 from a mutual fund in combined dividends and capital gains, and the net asset value is $10.00 per share, you are able to purchase 20 more shares of the fund. Sounds great, right? Now comes the disappointing part.

Due to the tax laws that are applied to mutual funds, mutual funds each year are required to payout 95% of capital gains and dividends they earn to fund shareholders. This would be great except for the fact that you are taxed on them. Furthermore, they really don't add to your economic position in the fund because they are paid out of the funds assets, resulting in a reduction of the NAV. For example if ABC mutual fund distributes capital gains and dividends of $.50 per share on a $10.00 net asset value, the new adjusted net asset value reduces to $9.50 per share hence you are in the same economic position.

Do I need to change the funds in my portfolio?

from Reddy

Q: As a holder of mutual funds that I hoped would provide a reasonable level of future security, I have become skeptical. After a year and a half of disastrous performance I have decided I need to learn more about the stock market and options trading. 

I have come to believe that typical mutual fund strategies are seriously flawed. Typical funds have a philosophy that does not address the changing stock market sentiment. Recently I have learned about bear market funds that can demonstrate amazing results during bear markets. Unfortunately these funds operated under a fixed philosophy that insures poor performance in bull markets.

Do you know of any funds that have dynamic philosophies? I’m looking for a fund that tries to predict the direction of the market using various technical tools, then modifying its investments accordingly. I’d expect such a fund might use an aggressive growth strategy during bull markets and shift to shorting stocks and trading put options during bear markets.

My advisor tells me that over the long haul, mutual funds will generate profits and that funds use bear markets to buy stocks cheaply. I know there is some truth to this, but I think that if you have a clear vision of impending disaster and the ability to do something about it, you should.

A: (Paul) If you think mutual funds threaten your financial security, just wait until you start trading options. I think you’ll get a taste of what volatility and risk really are. Maybe that’s the only way for you to learn some important lessons that other investors have already learned and have tried, apparently without a lot of success, to pass on to you.

These lessons include patience, diversification, humility and realistic expectations.

Here are three suggestions: If you believe you’ve found an advisor or fund manager who has a “clear vision” of the market’s near-term future, by all means invest some of your money with that advisor. Invest enough so that you will feel some pain if your confidence happens to be misplaced and enough that if you are right you will experience some significant reward. But don’t invest so much that you will jeopardize your financial future.

Second, if you personally feel a sense of impending doom, that’s a sign that you have exceeded your risk tolerance. In that case, go to cash until you feel better. Following your emotions is a lousy way to time the market. But you sound like somebody who is heavily influenced by emotions.

Important Disclaimer

Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.

International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.

Lastly, the questions and responses set forth here are for general informational purposes only and are not intended to substitute for performing your own independent research or contacting your financial or legal professional before making any investment decisions. We make no guarantees as to the performance of any investment strategy you choose and are not responsible for any losses you might incur.