I’d like to start with a seemingly simple question: Suppose you’d 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 would 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 did this happen—how could a six-figure gain turn into a loss? In reality, Jane didn’t experience a loss in this investment. She did quite well. What happened, though, was a function of the way mutual funds work—especially actively-managed funds like the one in which Jane was invested.
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 is 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. However, a key stipulation of the law 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.
And that’s exactly what happened with Jane’s fund. She first bought into the fund in the 1990s. In the subsequent years, the fund’s managers regularly bought and sold investments within the fund, booking profits in the process. And 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. As a result, each time her fund made a distribution, Jane ended up buying more shares at higher prices. But as the fund continued to realize gains, it made ever-larger distributions, and this brought down the fund’s overall value, and thus its share price.
The result: Jane accumulated more shares over the years, but many of those shares ended up below their purchase price. In other words, Jane had a gain on her original investment of $19,000. But that was far outweighed by losses on many of those subsequent purchases at higher prices.
At first glance, this might seem like semantics. 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 when she sold all her shares in 2021. 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. And in 2015 she had gains of $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? Maybe her fund was even doing her a favor by spreading out the tax burden. You might think so, but there are a few wrinkles. 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. The 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, a fellow named 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 additional studies have come to that same conclusion. But why is that? For the most part, active managers underperform for a simple reason: because it’s hard to predict what will happen in the economy or with any one stock. Consider, for example, the stock of Meta Platforms—formerly Facebook—which dropped more than 25% yesterday in response to negative news. As a portfolio manager, it’s extremely difficult to navigate 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 in their funds as they choose. 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. In contrast, 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.
The result: When you hold an actively-managed fund, you lose control over the timing of gains. In fact, you lose control over the disposition of gains and losses altogether. Suppose Jane had owned an index fund instead of the active fund she owned. Instead of having involuntarily paid all those taxes over the years, with an index fund, she could have chosen herself when to realize gains by selling fund shares. And like a lot of high net worth investors, she might have paired some gains and some losses to further control her tax bill, or even donated some shares to charity. With an actively-managed fund, though, investors lose all 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 with actively-managed funds, where the manager is frequently buying and selling investments.
That said, if you do, for whatever reason, want to hold an actively-managed fund, there are steps you can take to mitigate this problem. Most importantly, try to buy the fund in a retirement account, where distributions wouldn’t be taxable. If that’s not an option, though, and you plan to buy an actively-managed fund in a taxable account, there are still some steps you can take: For starters, check the fund’s turnover history. Some active managers trade much more frequently than others. Also, don’t reinvest distributions. And avoid target-date funds, along with hybrid stock-bond funds, which may be composed of index funds but tend to trade more.