If you hold mutual funds in a taxable account then you are aware that many give capital gains distributions in December. That should frustrate shareholders since they will need to include those payments as taxable income even if they didn’t sell the fund. That’s why it’s a bad idea to buy mutual funds in early December. 

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Why are there capital gains payments? A fund must list all realized gains and losses during their fiscal year. If the realized gains are greater than the losses, the fund distributes the net gain to shareholders. In 2018 mutual funds paid a total of $511 billion in capital gains and in 2019 they paid $355 billion. It was “and is” a bull market.

This year I expect the gains will be substantial. That’s because many investors panicked out of stocks in February and March when the S&P 500 plunged 34 percent. Mutual funds were forced to sell holdings to meet redemptions. The more trading a fund does, the higher the potential capital gains payment.

Next year can be bad as well. With Tesla being added to the S&P 500, many index funds (and closet index funds) will be forced to reduce their other holdings to make room for Tesla. That trading can lead to a 2021 capital gains distribution, which is why I prefer Exchange-Traded Funds (ETFs) over mutual funds. 

ETFs don't have the same taxing 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 declare capital gains, but those are rare. That can happen with some of the leveraged or inverse funds, but those are not good buy-and-hold investments anyway. 

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 that 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 year given the year’s volatility. If you invest in a taxable account, think twice before buying a mutual fund before it declares its December capital gains and income. No, just wait until after the distribution or buy an ETF instead.