America’s rich have another reason to quit mutual funds

America’s 40-year love affair with the mutual fund looks to be over. Since Fidelity popularised them in the 1980s, they have been a staple of investment portfolios, with more than 100m Americans owning mutual funds in their retirement or brokerage accounts.

Yet exchange traded funds have been gobbling market share for years, and a big hike in the capital gains tax for wealthy investors that has been proposed by the Biden administration could accelerate the shift, since it is a reminder of what a tax-inefficient structure US mutual funds really are.

For sure, most of those 100m Americans hold funds in tax-free retirement plans but, for wealthy individuals who have maxed out their tax-free savings, mutual funds come with outsized risks of a chunky capital gains bill.

Managers are required to distribute the capital gain when a fund sells a stock that has appreciated — which they might do if they have cooled on the stock’s prospects or because they have to raise cash to meet investor redemptions — and those distributions are subject to capital gains tax. Fund managers go to some lengths to minimise such distributions, but they are often unavoidable.

Morningstar, the financial research company, sends out an annual bulletin highlighting the sums involved when they are announced around the year-end. It found that several growth funds paid out double-digit percentages of their net asset values last year following the bull run in technology stocks. Morningstar also revealed that many more mutual funds made payouts in the high single digits.

By contrast, the way ETFs are structured — investors buy and sell ETF shares from each other and fluctuations in demand are dealt with by creating and redeeming fund shares — means that managers do not typically have to sell stock. So such “taxable distributions” are rare.

ETFs offer a host of other advantages that explain their soaring popularity for investors big and small. Since they are freely available on the stock market, investors are not at risk of having to reshuffle their whole portfolio if they switch to a different broker with a different mutual fund line-up. In addition, ETFs do not come with the commissions that still bedevil parts of the mutual fund universe. Most investment styles available in mutual funds are now also available in ETF format.

Sure, there are taxable-distribution risks with some ETFs, such as those that invest in more esoteric equities or derivatives, and, yes, most mutual funds have cleaned up their act on fees to compete better. But the broad trend is likely to stay in place: nearly half a trillion dollars flowed out of US mutual funds last year, according to industry body the Investment Company Institute, while almost the same amount flowed into ETFs.

Jenny Johnson, chief executive of Franklin Resources, was among the asset management executives predicting that the proposed Biden tax changes could hasten the shift out of mutual funds by higher-rate taxpayers. But an even bigger threat looms: while mutual funds have long been the default options in company retirement plans, they are increasingly being swapped out for so-called collective investment trusts — funds that can offer employees the same investment strategies at lower cost.

A flight from mutual funds is a trend it pays to be ahead of, and the reason, again, is those taxable distributions.

Morningstar’s work shows how the biggest taxable distributions are often caused by big outflows from a fund, since that is when managers can find themselves with no choice but to sell the underlying stock. Last year, after a sustained period of underperformance, some big-value funds suffered heavy redemptions that triggered taxable distributions and tax bills for the remaining investors. As Morningstar analyst Christine Benz said at the time, “talk about adding insult to injury”.

The worst of both worlds is an equity bull market that has caused the stocks in mutual funds to appreciate sharply and these accelerating investor redemptions that force managers to sell them. Taxable distributions from mutual funds this year could be significant, just when the taxes on them seem likely to be heading higher. Investors who have not yet reconsidered the use of mutual funds in their portfolios may want to do so, and soon.

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This article is part of FT Wealth, a section providing in-depth coverage of philanthropy, entrepreneurs, family offices, as well as alternative and impact investment