Capital gains distributions: Put away the broad brush

December is the season. It is the season for the holidays and for the financial press to report on capital gains distributions. Many publications use a broad brush to paint a story that typically says: mutual funds = bad / exchange traded funds (ETFs) = good. Like too many headlines and stories we see today, the reality and details are lost in this simple narrative.

Yes, capital gains distributions look bad for many mutual funds. To understand the details behind the headlines, my colleague Mike Gavan has been scouring the websites of mutual fund families and compiling their reported capital gains estimates. As of Dec. 3, Mike’s analysis encompasses capital gains data on 181 different fund families and shows average capital gains distributions (as a percentage of the most recent net asset value (NAV)) for the following asset classes:


Asset class
2021 estimated
capital gains distribution
Based on partial reporting available
as of Dec. 3, 2021 
(% of net asset value)
 U.S. large cap  9.0%
 U.S. mid cap  9.4%
 U.S. small cap  11.7%
 Non-U.S. stock funds  6.5%
 Municipal bonds  0.7%

Source: Russell Investments. *Calculated from publicly available data through Morningstar. All information is as of 12/3/2021 and any new distribution data released after this date is not considered and all information should be considered an estimate and subject to change prior to the payment date. Numbers of the funds included for average calculation are 3,115 out of 3,915 for U.S. Large Cap, 1,169 out of 1,423 for Mid-Cap, 1,354 out of 1,712 for Small Cap, 3,504 out of 4,100 for Non-U.S. Stock Funds and 1,630 out of 1,822 for Municipal Bonds. For the details of the calculation, see below.

To put dollars behind these percentages, if a taxable investor had an investment worth $100 at year-end in the average U.S. large cap fund, they would receive a Form 1099 for the Internal Revenue Service (IRS), with a $9 taxable distribution (9% X $100). Even if the investor chose to re-invest the distribution back into the fund, this may trigger a taxable event.

Note the 0.7% estimated average capital gains distribution for municipal bonds. While the interest income is generally tax-free at the federal level, there may be taxes due on the sale at a gain of underlying bonds in the fund. Many folks evaluating municipal bond funds overlook this important point.

Bear in mind, these are averages. We know some distributions are higher, some are close to the average and some are lower. The headlines remind me of the story about the six-foot tall hiker who drowned crossing a creek that had an average depth of three feet. Averages mask the actual path!

Looking outside our own analysis of distributions,—which also tracks capital gains across the mutual fund industry—reports that through Nov. 28, 2021:

  • More than 750 mutual funds will have an estimated capital gains distribution higher than 10% of NAV
  • Of those, more than 148 will be higher than 20% of NAV

Affected taxable investors should brace for painful tax bills flowing from the Form 1099.

The broad brush

A reader of the stories in the financial press may come away thinking that all mutual funds are inferior to ETFs and index funds when it comes to capital gains distributions. In fact, many of these stories predict the demise of mutual funds. For sure, the outliers on the high side are targets for the headlines as referenced above—and for good reason. But like the hiker just mentioned, the average and worst performers mask compelling mutual fund alternatives—such as tax-managed equity funds.

As recently reported by Financial Times1, ETFs can also have capital gains. The newspaper reported that 9% of ETFs offered by BlackRock, Vanguard and State Street Global Advisors are expected to distribute capital gains this year. And 2% of the 415 equity ETFs collectively will distribute capital gains. 2% is larger than 0%. Same for index funds. They can—and many often do—have capital gains distributions.

The same Financial Times article goes on to say that active ETFs that do not passively track a benchmark could be less tax efficient due to higher turnover. For these, it’s too early to determine the full capital gains effect until they reach more mature status.

When discussing tax impact, remember that tax drag is also worsened by income distributions (dividends and interest income). Don’t forget to add the impact of both capital gains and income. If your client does not need income and is reinvesting distributions, they are creating additional headwinds for their after-tax returns.

How can you measure tax efficiency for mutual funds and ETFs? Visit our Tax Impact Tool where we report on the return lost to taxes (tax cost ratio) and after-tax return for our tax-managed funds and most funds/ETFs available to U.S. investors. In our discussions with advisors over the years about the importance of after-tax returns, we saw how hard it was for advisors to make informed decisions on after-tax returns. We created this tool to help.

Consider an alternative that is designed to purposefully strive for lower tax bills in an effort to maximize after-tax returns: tax-managed equity funds and tax-exempt bond funds.

Most equity mutual funds are indifferent to taxes. The portfolio manager and investment process are all about the pre-tax return. The portfolio manager is likely measured and compensated on pre-tax return. That is not necessarily bad, but too often does not line up with the objectives for taxable investors.

Tax-managed equity funds do consider the impact of taxes. The entire investment process aims to maximize after-tax returns to include minimizing taxable distributions. For these funds, tax minimization is not incidental to the process, but purposeful and intentionally built into the active investment process. Click here to learn more about Russell Investments’ process.

Reporting on averages across tax-managed equity offerings also can mask a wide range of after-tax outcomes. Not all tax-managed equity funds are equal in the eyes of the IRS. Do the research to make sure you understand the process, the people and investment approach in striving to achieve after-tax returns. A thoughtful review will reveal compelling offerings with regards to possible lower taxable distributions and attractive after-tax returns.

At times, realizing gains may be necessary to take advantage of strong market environments like we just experienced and allow for the benefits of active tax management to come through. For the taxable investor, the goal is not only to minimize the amount of taxes owed, but to maximize the after-tax return

Cap gains and Steph Curry

Averages have their place and help convey a broad picture, but the details often tell a different story. I was watching basketball with my brother (a huge Golden State Warriors fan) and his family when they visited over the Thanksgiving holiday. The announcers were talking about the team’s free throw shooting average and it reminded me of how the financial media reports capital gains taxes for mutual funds (yes, in my life it always comes back to taxes). For the Warriors as a team, their free throw average is 76.8%. The best free throw shooter is Steph Curry with a 94.3% average and the worst is Kevon Looney at 55.6%. 

Many headlines would only focus on the worst shooters and mention the team average. While somewhat helpful, this approach would mask the details.

Same for capital gains and taxable accounts. Who do you want managing your investments and working to maximize after-tax return? The average shooter? The worst shooter? No. Your clients want the coach (advisor) to do the research and put the best player on the line—the one who practices diligently, is an expert and has a proven record. Most would take the odds with Steph Curry on the line during a tight game. That is how we see our tax-managed offering: a demonstrated/measurable track record, committed process and a laser focus that helps to improve the odds for taxable investors.

Don’t let your clients drown in taxes crossing a creek that has an average depth of three feet.

1 as of 12/3/2021. Only considered players with more than 35 free throw attempts to keep Arkansas Razorback rookie Moses Moody off the list!