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is why you should pay close attention to the fund’s management style and more specifically its historical turnover ratio. The higher a fund’s turnover ratio, the more capital gains distributions are to be expected. This is one area you do have a choice in. If you want to avoid high capital gains income, you should go with a fund that has a low turnover ratio. There are also tax-friendly funds out there that have very low turnover ratios or invest in tax-free securities such as municipal bonds (munis) whose coupon payments are not subject to tax. That is not to say that funds with high turnover ratios are bad. If they deliver consistently good returns, they would obviously be preferable to a low turnover fund that has a poor track record. The turnover ratio and the fund’s potential tax liabilities is only one piece of information and should be considered, together with the other data.

An Example

Earlier I mentioned that investing in funds may have tax pitfalls, and that one of the most important pitfalls that many investors overlook is the fund’s distribution schedule. Let’s look at an example to illustrate this. Suppose you buy 100 shares of a fund at $50 per share (at a cost of $5,000) at the end of November, and the fund is scheduled to make a capital gains distribution of $25 per share in early December, perhaps one week after your purchase. Chances are that the fund’s NAV would not change by much during that week. So one week later you will receive a distribution of $25 per share ($25 x 100 = $2,500) and the fund’s NAV is adjusted accordingly to $25. As you can see this distribution has no net effect on your invested money. You are still worth $5,000. And if you have specified automatic reinvestment, your proceeds will be immediately reinvested bringing you to 200 shares of the fund at $25 per share (barring any re-investment fees). …