Potential Capital Gain Exposure Research Paper
Potential capital gain exposure (PCGE) is an estimate of the percent of a fund�s assets that represent gains. PCGE measures how much the fund�s assets have appreciated, and it can be an indicator of possible future capital gain distributions.
Morningstar calculates PCGE to give investors some idea of the potential tax consequences of their investment in a fund. PCGE measures the gains that have not yet been distributed to shareholders or taxed. It is especially relevant for investors who are considering a new purchase of a fund. If there are a lot of gains embedded in the fund, investors may potentially receive capital gain distributions for gains that happened before they purchased the fund.
A positive PCGE means that the fund�s holdings have generally increased in value. For example, if a fund started with $2,000, gained $500 and lost $100, the fund�s PCGE would be 17%, i.e. the net $400 gain divided by the total net assets of $2,400. The fund can either continue to hold the securities that appreciated or it can sell them. When a fund sells a security at a gain, it must distribute substantially all of those gains to shareholders that year. Investors then must pay taxes on those gains. So, a high PCGE can indicate the potential for upcoming capital gain distributions.
A negative PCGE means that the fund has reported losses on its books. For example, if a fund started with $2,000, gained $100 and lost $500, the fund�s PCGE would be -25%, i.e. the net $400 loss divided by the total net assets of $1,600. The fund may be able to use those losses to offset future gains, thereby reducing the possibility of a capital gain distribution. Thus, investors should expect funds with negative capital gain exposure to be highly tax-efficient going forward.
Morningstar uses data from the fund�s annual report as the basis for potential capital gain exposure. To keep the calculation current, we update the information between shareholder reports by accounting for a fund�s recent 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 recalculated on a monthly basis. The updated figure is more of an estimate than the one based solely on data from the shareholder report, but it is more current and therefore more relevant to the investor. Morningstar calculates this statistic for open-end mutual funds, closed-end funds, and variable annuity underlying funds.
The formula for potential capital gains exposure is simple:
Gains (Losses)/Current Assets
The numerator can be broken down into four components. Gains (Losses) is composed of:
Unrealized Appreciation (Depreciation): from the annual report
plus
Realized Gains (Losses): from the annual report
plus
Recent Appreciation (Depreciation): in the months since the annual report
minus
Recently Distributed Capital Gains: in the months since the annual report
A high potential capital gain exposure does not always mean that the fund will distribute capital gains in the near future. The gains Morningstar measures are both unrealized (securities not sold yet) and realized (sold). Funds are not required to distribute gains to shareholders until they sell the securities to realize those gains.
A high PCGE is generally not a cause for concern in a bond fund. When interest rates fall, bond prices rise. However, the capital gain is temporary, because as the bond gets closer to maturity, the price converges with the face value of the bond. Many of these temporary gains will never be realized, especially if the fund owns the bond until maturity.
Investors should consider a few factors in addition to high PCGE to determine the likelihood that the fund will make a capital gain distribution. Any circumstance that causes a portfolio manager to sell securities will increase the likelihood that a fund will realize and distribute capital gains. Stock sales may be accompanied by a high turnover rate, manager changes, strategy changes, and large redemptions. Additionally, most funds tend to accumulate capital gains throughout the year and distribute them to shareholders in December.
Because the fund's asset base serves as the denominator in the PCGE 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 high potential capital gain exposure does not always mean that the fund will distribute capital gains in the near future. The gains Morningstar measures are both unrealized (securities not sold yet) and realized (sold). Funds are not required to distribute gains to shareholders until they sell the securities to realize those gains.
A high PCGE is generally not a cause for concern in a bond fund. When interest rates fall, bond prices rise. However, the capital gain is temporary, because as the bond gets closer to maturity, the price converges with the face value of the bond. Many of these temporary gains will never be realized, especially if the fund owns the bond until maturity.
Investors should consider a few factors in addition to high PCGE to determine the likelihood that the fund will make a capital gain distribution. Any circumstance that causes a portfolio manager to sell securities will increase the likelihood that a fund will realize and distribute capital gains. Stock sales may be accompanied by a high turnover rate, manager changes, strategy changes, and large redemptions. Additionally, most funds tend to accumulate capital gains throughout the year and distribute them to shareholders in December.
Because the fund's asset base serves as the denominator in the PCGE 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 high potential capital gain exposure does not always mean that the fund will distribute capital gains in the near future. The gains Morningstar measures are both unrealized (securities not sold yet) and realized (sold). Funds are not required to distribute gains to shareholders until they sell the securities to realize those gains.
A high PCGE is generally not a cause for concern in a bond fund. When interest rates fall, bond prices rise. However, the capital gain is temporary, because as the bond gets closer to maturity, the price converges with the face value of the bond. Many of these temporary gains will never be realized, especially if the fund owns the bond until maturity.
Investors should consider a few factors in addition to high PCGE to determine the likelihood that the fund will make a capital gain distribution. Any circumstance that causes a portfolio manager to sell securities will increase the likelihood that a fund will realize and distribute capital gains. Stock sales may be accompanied by a high turnover rate, manager changes, strategy changes, and large redemptions. Additionally, most funds tend to accumulate capital gains throughout the year and distribute them to shareholders in December.
Because the fund's asset base serves as the denominator in the PCGE 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.
Potential Capital Gain Exposure Research Paper