Some mutual funds have long-term appreciation as their investment objective. These tend to have relatively low capital gains. Other funds pursue high returns by actively buying stocks with upward price momentum and selling stocks as their momentum declines, a strategy that produces high turnover rates. Once an asset is sold, the profit becomes a capital gain. Mutual funds that pursue high returns with strategies producing high turnover rates also generate high capital gains.
Generating High Alphas
Some actively managed mutual funds state that their investment objective is to generate high alpha -- to generate returns on investment exceeding the benchmark for its investment class. Take, for example, a large cap growth fund -- a fund investing in large corporations with better than average recent increases in price -- that returns a 23 percent gain over the previous 12 months. If the benchmark for large cap growth funds during that period is 21 percent, the fund has exceeded its benchmark by 2 percent. Its alpha is 2.0. Another, more sophisticated way of computing alpha also takes the fund's risk into account.
The Price of High Capital Gains
Generally, funds trying to achieve high alphas are aggressive growth funds with relatively high turnover rates that drive up trading costs; when the strategy succeeds, they also generate high capital gains. Funds generating high capital gains tend to have increased volatility and higher than average risk profiles. While such funds can achieve relatively high returns, they can also return greater than average losses. An academic study led by Theodore Day concludes that high-turnover funds tend to underperform the mutual fund industry average.
Funds With Low Capital Gains
Smaller companies, such as those listed on the Russell 2000 index, tend either not to issue dividends or to declare lower dividends than the companies listed on the Dow Jones Industrial Average -- an index of 30 of the largest U.S. companies. A mutual fund company that either passively manages a portfolio matching an index of smaller companies, such as the Russell 2000, or that has as its investment strategy holding smaller companies in the fund over long periods usually has lower taxable capital gains than growth funds seeking to generate high alphas.
High Capital Gains and Taxes
By law, mutual fund companies must distribute almost all gains to their shareholders as capital gains distributions either once or twice each year. If the fund holds these equities for at least one year, the profits are taxed at the long-term capital gains rate. For 2013, these rates range from 0.0 percent through 23.8 percent. If the fund has high turnovers, some or all of the capital gains distribution may be for funds held for less than a year; these are taxed at the short-term capital gains rate, which ranges from 10 percent to 39.6 percent. A mutual fund can achieve high performance, but if it generates excessive short-term capital gains, the net return to the investor may be disappointing.
Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.