I’D LIKE TO START with a seemingly simple question: If you purchased an investment for $19,000 and later sold it for $287,000, would there be a gain or a loss? If you answered that there would be a gain, I’d agree with you. Specifically, it appears the gain would be $268,000. But what if there was no gain and the investment was actually sold at a loss? Could that be the case?
This scenario isn’t hypothetical. This was the recent experience of a client. Let’s call her Jane. Normally, I wouldn’t discuss a specific family’s finances. But in this case, Jane was so surprised—and I was too—that she felt it might benefit others to describe her experience.
How could a six-figure gain turn into a loss? In reality, Jane didn’t experience a loss. She did quite well. What happened, though, was a function of the way mutual funds work, especially actively managed funds like the one Jane owned.
To understand this, we need to go back to the 1940 Investment Company Act, which governs mutual funds. One of its provisions allows mutual funds to be treated as “pass-through entities” for tax purposes. In other words, mutual funds themselves aren’t subject to income taxes. Instead, a fund’s tax bill can be shared pro-rata by its shareholders.
That’s an important and valuable provision because it prevents a situation in which income would be taxed twice, as it is in other cases, such as when a public company pays a dividend. A key stipulation of the law, however, is that a mutual fund must pay out at least 90% of its income to its shareholders to be eligible for this favorable tax treatment.
That’s exactly what happened with Jane’s fund. She first bought into the fund in the 1990s. In subsequent years, the fund’s managers regularly bought and sold investments within the fund, booking profits in the process. When they did, those profits were passed along to shareholders. These are called distributions, and they’re taxable to shareholders in the year that they’re distributed.
When a distribution is paid, some shareholders elect to receive them in cash, while others choose to automatically reinvest the proceeds back into the fund. Jane opted for the latter. Each time her fund made a distribution, she ended up buying more shares. Those purchases added to her cost basis for tax purposes.
Over the decades, as the fund continued to realize gains, it made ever-larger distributions, and this brought down the fund’s share price. Suppose a fund distributes 50 cents a share. When that distribution is made, the fund’s share price will drop by a comparable amount. The upshot: Jane accumulated more shares over the years, but many of those shares ended up being worth less than her purchase price. At first glance, this might seem immaterial. If Jane made a profit overall—which she definitely did—then isn’t that all that matters? In my opinion, no—for several reasons.
As I noted above, Jane’s holdings in the end were worth nearly $300,000 and yet, for tax purposes, she was able to declare a loss for 2021 when she sold her shares, thanks to all the distributions that she’d reinvested and which added to her cost basis. But there was no free lunch here. Jane did pay taxes on that big gain. It’s just that she paid taxes on her gains along the way. In 2014, for example, she had gains of $20,600, while in 2015 her taxable gains were $54,500.
On the surface, this might seem like a benefit. Isn’t it better to pay a bill incrementally rather than all at once? You might even imagine that her fund was doing her a favor by spreading out the tax burden. But there’s a few wrinkles to consider. The first is the time value of money. All things being equal, you’d much rather pay a bill later rather than sooner. In Jane’s case, including state taxes, she probably paid more than $100,000 in taxes years earlier than she needed to. That’s a problem because she could have invested or used that $100,000 in those earlier years.
There’s another aspect to this less-than-ideal tax result: Today, Jane and her husband are mostly retired and thus in a low tax bracket. But in many of the years when this fund was distributing big gains, Jane was in a much higher bracket. Result? She paid taxes sooner than necessary because of the fund’s active trading, and she paid those taxes at higher rates than she might have later.
Back in 1932, Alfred Cowles III published a paper titled, “Can Stock Market Forecasters Forecast?” Cowles’s finding: Active portfolio managers, on average, lag the overall market. In the years since, multiple other studies have come to the same conclusion.
Why this underperformance? For the most part, active managers trail the market averages for a simple reason: It’s hard to predict what will happen in the economy or with any one stock. Consider the stock of Meta Platforms—formerly Facebook—which dropped more than 25% on Thursday in response to negative news. As a portfolio manager, it’s extremely difficult to anticipate these sorts of events, which happen all the time.
But as Jane’s experience reveals, actively managed funds pose another obstacle for investors: They can be extremely tax-inefficient. That’s because active fund managers have the latitude to buy and sell investments as they see fit. That’s in contrast to index funds, which trade much less frequently—only when the index itself changes.
By way of comparison, the largest actively managed stock fund, the Growth Fund of America, had turnover of 24% in the most recent year. Meanwhile, the largest index fund, the Vanguard 500 Fund, had turnover of just 1.1%. What’s worse, the gains generated by actively managed funds are totally unpredictable—subject to the portfolio manager’s choices.
Suppose Jane had owned an index fund rather than an actively managed fund. With an index fund, instead of having involuntarily paid all those taxes over the years, she could have chosen herself when to realize gains by selling some of her fund shares. Like a lot of high-net-worth investors, she might have paired those gains with some realized losses to further control her tax bill, or even donated some shares to charity. With an actively managed fund, investors lose much of that control.
I see this as another reason to steer clear of actively managed funds and to opt instead for index funds. To be sure, index funds aren’t perfect—and they do sometimes make surprise distributions. But the reality is that the phenomenon Jane experienced is most pronounced among actively managed funds, where the manager is frequently buying and selling investments.
What if you want to hold an actively managed fund? Try to buy the fund in a retirement account, where distributions wouldn’t be taxable. What if that isn’t an option and you’re thinking of buying an actively managed fund in a taxable account? Check the fund’s turnover history. Some active managers trade much more frequently than others. In addition, consider taking your distributions in cash, rather than reinvesting them, so you have the option of investing the money elsewhere. Finally, in your taxable account, also avoid target-date funds and hybrid stock-bond funds, even if they’re composed of index funds, because these funds tend to trade more and thus can be quite tax-inefficient.