I want to talk to y’all quickly today about the “dark side” of mutual funds. Now I want to preface this by saying mutual funds are actually a great way to achieve diversification with just one holding, I’m not saying mutual funds are bad.  

If you don’t know, mutual funds are a collection of individual stocks, individual bonds, or sometimes a combination of both – so it’s a way to hold one investment and gain access to hundreds, maybe thousands, of holdings that are managed by a mutual fund manager. That’s why you see mutual funds in your 401(k)’s, it’s a great way to achieve some diversification! 

Quick side note – if you are looking for overall diversification, make sure you hold multiple mutual funds so that you have a piece of everything – both U.S. stocks, international stocks, bonds, mid & small-caps, the gambit because one fund is not going to give you diversification across everything.  

But I did want to talk about that “dark side” of mutual funds. The reason I want to talk about that is because nobody loves taxes. This “dark side” of mutual funds is what we call a phantom capital gain. What I’m talking about here is only applicable if you are holding mutual funds in a taxable account. In your retirement accounts (401(k)’s and IRA’s), because there are no capital gains in those accounts, these phantom gains don’t apply. In a taxable account, if you buy a mutual fund and you hang onto it, it grows, and later on, down the road, you decide to sell, you have a gain in the fund and that gain is taxed to you as a capital gain. If you buy that same mutual fund, hang on to it, and then decide not to sell, at the end of the year you may still get a capital gains tax – and that’s where that phantom gain comes in. The reason this happens is because there are other people holding that same mutual fund, and if they choose to sell their shares of the mutual fund, well the manager has to go in and sell some of the underlying securities within that mutual fund to give them their dollars. The reason people may do this is if that mutual fund grew all year long like it may have last year, they decided to take some of the gains off the table. Or maybe there was a correction in the middle year, and they freaked out wanted to sell the mutual fund then. There are multiple reasons why that manager may have to sell throughout the year, even though you chose not to because you were cool with the growth, or you didn’t get freaked out at the wrong time. Either way, that manager had to make a trade to get that cash available, so the individual stocks within the mutual fund had their own gains and the mutual fund manager is now passing those gains along to everybody who held that mutual fund throughout the year. 

Unfortunately, this phantom gain is not really avoidable, unless you’re either holding a mutual fund in those retirement accounts or you’re holding individual stocks and bonds themselves. But if we’re trying to achieve that diversification with the mutual fund (of holding one fund and getting access to hundreds of securities) you can’t really have your cake and eat it too unless you’re holding hundreds of individual stocks yourself. It’s also not necessarily a bad thing, because capital gains means the account’s doing what you want, it’s actually going in an upward direction! You can even call it a success tax if you want.  

I just want y’all to be aware because we did just hit the end of the year and you might see some of these start to come out. I don’t want you to freak out and question why you’re getting the capital gains tax even though you chose not to sell your fund throughout the year. Just something to keep in mind come tax time – it is a “dark side” to mutual funds, but as I said earlier mutual funds can be a great tool when you’re looking to invest. Y’all have a good one!