Mutual funds were a financial innovation that democratized investing. Decades ago, when trading costs were high and access to diversified portfolios was limited, mutual funds provided everyday investors with professional management and broad market exposure.

As investor wealth grows, however, the limitations of mutual funds become more apparent. In taxable accounts, one structural feature in particular can quietly erode after-tax returns: mutual funds can force investors to recognize capital gains even when they have not sold a single share.

Mutual Funds Create Forced Capital Gains

Mutual funds pool capital from many investors and manage a single portfolio on their behalf. When the fund sells a security at a profit, the realized gain must be distributed to shareholders for tax purposes. The IRS requires mutual funds to pass through nearly all realized capital gains each year.

These distributions are entirely independent of an investor’s personal circumstances. An investor may hold a fund for years, never sell a share, and still receive a taxable capital gain. In some cases, investors owe taxes even in years when the fund’s net asset value declined.

Investor behavior can amplify the problem. When shareholders redeem fund shares—often during market downturns—the fund may be forced to sell appreciated holdings to meet redemptions. The resulting gains are distributed to remaining shareholders, meaning long-term investors can bear the tax consequences of other investors’ decisions.

Because capital gains distributions are typically announced late in the year, they are difficult to anticipate and often come as an unpleasant surprise.

Long-Term Cost of Tax Inefficiency

Taxes do more than reduce wealth, they reduce the amount of capital available to compound over time. Paying taxes earlier than necessary creates a persistent drag on long-term returns.

Two portfolios with identical pre-tax performance can produce meaningfully different after-tax outcomes depending on when gains are realized. Mutual funds remove that timing decision from the investor’s control.

Tax-efficient funds along with index-based mutual funds and ETF’s have softened the tax impact but have yet to solve the issue entirely. Portfolio rebalancing, index changes, and investor flows can all trigger taxable gains regardless of the manager’s intent.

Advantage of Owning Individual Securities

Portfolios built from individual stocks and bonds offer a fundamental advantage: control. When investors own securities directly, gains are typically realized only when a position is sold.

This allows for deliberate tax management, harvesting losses to offset gains, deferring sales of appreciated positions, donating securities to charity, or gradually trimming positions over time. In many cases, assets can be held until death, potentially allowing heirs to benefit from a step-up in cost basis.

Just as important, investors can often avoid unnecessary tax events altogether. When there is no need to raise cash or rebalance aggressively, securities can simply be held.

Mutual funds still have a place in investing but as wealth grows and taxable assets become a larger portion of a portfolio, tax efficiency becomes increasingly important. At that stage, how investments are structured can matter just as much as what is owned. For many long-term investors, portfolios of individual securities provide a more efficient path to compounding wealth.

 

Past performance is not indicative of future results. The material above has been provided for informational purposes only and is not intended as legal or investment advice or a recommendation of any particular security or strategy. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Information obtained from third-party sources is believed to be reliable though its accuracy is not guaranteed, Beese Fulmer Private Wealth Management (“Beese Fulmer”) makes no representation or warranty as to the accuracy or completeness of the information, which should not be used as the basis of any investment decision. Information contained on third-party websites that Beese Fulmer may link to is not reviewed in their entirety for accuracy and Beese Fulmer assumes no liability for the information contained on these websites. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of writing and are subject to change without notice. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Beese Fulmer. For more information about Beese Fulmer, including our Form ADV brochures, please visit https://adviserinfo.sec.gov and search for our firm name.