A "Taxing" Problem For Mutual Funds

For a few reasons, I prefer exchange-traded funds (ETFs) to mutual funds. Mutual funds, with about $20 trillion under management, remain a bigger asset class than ETFs, but most of the investing advantages favor ETFs. The month of December points out one of the flaws in mutual funds ... they are not tax efficient.

For taxable accounts, it's a bad idea to buy mutual funds in early December. That's because most mutual funds distribute a capital gains payment to shareholders. The shareholders need to claim those payments on their taxes, even if they only held the fund for a few days or have a capital loss on the investment. Here's why:  Mutual fund managers constantly sell securities in order to meet redemptions or rebalance their assets. The capital gains from the sales are passed on to shareholders. This year, the gains may be substantial.

ETFs don't have that problem. They meet redemptions with an "in kind" redemption of shares. ETFs are treated like stocks, so investors only have to pay capital gains on net realized profits.

There are some cases where ETFs pass on capital gains, but they are rare. That can happen with some of the leveraged or inverse funds, but those are not good buy-and-hold investments anyway.

Tax efficiency is one of the reasons ETFs are preferred by many over mutual funds. Another is lower management fees. When you compare like securities, ETF fees are almost always lower than mutual funds. Mutual fund companies also see this advantage, which is why traditional mutual fund companies like Fidelity and Vanguard have introduced ETFs.

One can make a case for investing in mutual funds. If you have an IRA and automatically invest each month or quarter then the mutual fund format is fine, especially if the account is not large. If this fits your profile, be sure to have dividends and capital gains reinvested to take full advantage of compounding. Of course, ETFs can be used in IRAs as well.

Investing in ETFs instead of mutual funds makes more sense. That will be especially true this December given the market’s 25 percent rise this year. If you invest in a taxable account, think twice before buying a mutual fund before it declares its December capital gains. No, just wait until next year or buy an ETF instead.