What does potential capital gains exposure percentage mean when choosing a index fund? For example; Index Fund (1) has a 23% potential capital gains exposure and Index Fund (2) has a -1% potential capital gains exposure. Is one better than the other? Does it matter?
Out of curiosity, where are you seeing that?
This is a relatively obscure topic that has recently made some headlines with Vanguard’s target date funds.
Basically, mutual funds are a big shared account. Each individual investor puts their money in, then the fund buys stuff inside. That stuff inside can go up in value a lot. When the stuff inside has gone up in value, that represents a “capital gain”. Capital is stuff. Gain is going up in value. If the fund ever has to SELL that stuff inside for some reason, it then “realizes” the gain. That means, they have to tell the government, “Hey we made a bunch of money and now owe tax on it”. But the fund doesn’t pay the tax directly, they just pass that tax bill on to the investor.
What does this mean for you? Let’s say you buy into Index fund A. That fund is very old and has done very well. It has $500M in it and 50% of that is “capital gains”. Then, Index Fund A’s biggest investor wants all their money back. So the fund sells hundreds of millions of dollars to pay the investor.
What happens THEN is the share price drops because the NAV (net asset value) drops to cash all that out. You the investor GETS your fair share of that cash out (which can/should be reinvested) leaving you exactly where you were. BUT, you get a big tax bill since YOU just realized that gain.
ALL THAT SAID, this almost never is actually a problem because index funds are generally growing and don’t have to sell stuff. BUT if you buy into a fund with a big “capital gains exposure” you run the risk of getting hit with a tax bill you don’t want. It’s not actually a HUGE deal because it’s tax you would have owed anyway or you have a NAV share price drop that can offset it. But it is likely “not optimal” if it’s early in your investing timeframe.
By the way, ETFs don’t have this problem.
Here’s a YouTube vid I made walking through this issue when it happened to Vanguard’s target date funds: Huge Tax Bill From Vanguard Funds?! - YouTube
tldr: Likely not a big deal. But smaller is better. Or go with ETFs to avoid it all together.