The Truth Behind the S&P 500: Part IV

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This is the time of year when you need to be extra careful about what you invest in, especially when you’re buying a so-called passive index fund that tracks the S&P 500.

I have many concerns about the S&P 500 index approach, as I point out here, here, and here.

Add one more issue to the list: “Passive” investors paying for someone else’s actions.

Recently, the PNC S&P 500 Index Fund announced it will pay out $4.19 in cap gains per share, as pointed out in by Jason Zweig in his weekly WSJ column The Intelligent Investor.

“This week, the fund’s per-share value was around $19. So, even if you never sold a share, the fund will pay out nearly 22% of your total investment as a taxable gain,” writes Zweig.

Talk about coal in your stocking.

Zweig continues:

How can that happen?

In general, when investors exit a fund, it may cash out of some of its holdings, potentially generating a taxable gain that must be paid out to the remaining shareholders.

In recent years, at least, more investors have wanted to buy index funds than sell, tending to make such portfolios unusually tax-efficient. Vanguard 500 Index Fund hasn’t paid out a capital gain since December, 1999, according to Morningstar; State Street Institutional S&P 500 Index Fund hasn’t paid one since December, 2000.

A spokesman for PNC Funds declined to comment.

However, investors withdrew $63 million from the fund, or 38% of its assets, over the 12 months through Sept. 30, Morningstar estimates.

The manager of an index fund doesn’t have much flexibility on which shares to sell when investors want their money back, says Mark Wilson, president of Mile Wealth Management in Irvine, Calif., whose website CapGainsValet.com warns about taxable payouts.

That’s because such a portfolio needs to hold stocks in similar proportions to the index it’s seeking to match. So the manager can’t always sell selected holdings at a loss that would offset gains elsewhere. Instead, he or she has to sell pretty much across the board, which can generate unwanted capital gains.

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E.J. Smith - Your Survival Guy

E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. His focus at all times is on preparing clients and readers for “Times Like These.” E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zildjians. He grew-up worshiping Neil Peart (RIP) of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West (RIP JB) and Paris. Please get in touch with E.J. at ejsmith@yoursurvivalguy.com To sign up for my free monthly Survive & Thrive letter, click here.

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