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ON NOVEMBER 21, 2025, a mutual fund managed by Royce Investment Partners (ticker: RDVIX) saw its share price drop more than 60% overnight.
What happened? In this case, nothing dramatic. But this surprising price move illustrates an aspect of mutual funds that often flies below the radar. Under IRS rules, mutual funds are obligated to distribute at least 90% of earnings to their shareholders each year to avoid being taxed themselves. That includes dividends or interest produced by the investments the fund holds. And it includes capital gains generated by the fund manager’s own trading.
In the case of the Royce fund, the fund manager was particularly active last year, and as a result, generated significant capital gains. To meet the requirement to distribute the bulk of those profits by year-end, the fund manager picked that day in November and arranged for this distribution.
Why did the share price drop so significantly? This is where the distribution process gets a little thorny, so we’ll walk through it step by step. On the day before the distribution, the fund’s closing share price was $5.72. Then, immediately after the market closed, a distribution of $3.77 per share was issued. The fund paid this out of its cash reserves. As a result, after the distribution, the fund was that much smaller. And because that cash was no longer in the fund but instead in investors’ hands, the fund’s share price started the next day that much lower.
How did that affect the fund’s shareholders? On the day after the distribution, their shares were worth $3.77 less, but they’d also received $3.77 in cash. So from investors’ perspective, they were no worse off.
If that’s the case, though—that shareholders were no worse off—then why are fund distributions worth discussion?
The issue is that distributions like this are taxable as income to mutual fund shareholders, if a fund is held in a taxable account. Each shareholder in a mutual fund pays his or her own pro rata share of the fund’s tax bill, but shareholders have no choice in the matter. If a fund manager decides that he likes Apple better than Amazon and places a trade that generates a gain, shareholders have no say in that decision and aren’t even notified until later, when a distribution is announced.
In many cases, distributions are modest, and nearly every fund generates some income, if only from interest or dividends. That’s to be expected. But distributions generated as a result of fund managers’ trading are worth greater scrutiny.
As an investor, how can you know how actively a fund manager will be trading? There’s no way to know for sure, but two strategies can help you make an educated guess. First is to examine the fund’s track record. Past performance doesn’t guarantee future results, but it can provide clues. If a fund manager has been an active trader in the past, you might expect a similar pattern in the future. To get a sense of this, you’d simply visit the fund company’s website, where you’ll find a page detailing past distributions. If you see a pattern of big numbers in the capital gains category, that’s a red flag.
A more fundamental way to estimate what level of taxes a fund is likely to generate: Examine the fund’s strategy. In general, if it’s an index fund, it’s less likely to generate capital gains. But being an index fund is still no guarantee that a fund will be tax efficient. That’s because there are thousands of indexes out there, and some follow niche strategies that involve more trading. So always check out a fund’s track record.
So far, we’ve been looking only at traditional mutual funds. What about exchange-traded funds (ETFs)?
They’re often more tax efficient because of a feature available only to ETFs and not to mutual funds: They’re able to trade “in kind” with firms known as authorized participants. In simple terms, what this means is that ETFs are able to swap assets out without actually selling them, and that allows them to make portfolio changes without triggering a taxable event for shareholders. That’s a key reason I recommend ETFs over traditional mutual funds when the same investment is available in both formats. To be sure, ETFs can still generate capital gains distributions, and some do, but it’s much less common than with mutual funds.
Wondering about the tax efficiency of funds you already own? The place to start is Schedule D of your tax return. Look for a line that reads “capital gains distributions.” If there’s a material number on that line, you may want to investigate further. At the back of your tax return, there will probably be a table that breaks down the distributions, helping you identify the smoking gun.
If it turns out that a fund in your portfolio is generating outsized distributions, I suggest two ways you might think about it. If you’re in retirement, you might conclude that these distributions aren’t really a problem since you’d be selling assets anyway to meet expenses.
But if you’re in your working years and a net saver, that’s when you might consider ways to reduce your holdings in a fund that’s been tax-inefficient. If there isn’t much of a gain on your holding, you might simply sell it. But if it’s held at more of a significant gain, you’ll want to think about other ways to reduce the position over time. You might sell shares incrementally to spread out the tax impact or use them for charitable giving.
In the meantime, one easy step is to confirm that you aren’t automatically reinvesting distributions. At the margin, this can help in reducing your exposure to tax-inefficient funds.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Thanks for this article Adam. This why years ago I changed to ETF’s, that works for me.
I thought that Vanguard had a work around for this issue for some of its funds. A quick search turned up this article.