The myth about accrued gains and mutual funds

Everyone wants to own successful equity mutual funds. A successful equity mutual fund is one where a return is generated from the appreciation of the price of the stocks owned by the fund.

Additional return may be earned through dividends paid by the companies owned by the fund and from interest generated on any cash holdings. But clearly, the lion’s share of an equity fund’s return is generated in the form of capital appreciation in the value of the stocks owned.

Capital gains in a typical equity mutual fund may be either realized or unrealized. Within a mutual fund, when a stock investment increases in price, this is an unrealized capital gain. It is unrealized because the stock remains owned by the fund. Only when the stock is sold by the fund manager does the unrealized capital gain become a realized capital gain.

The frequency with which a fund manager buys and sells securities for a fund is called the portfolio turnover rate. Annual portfolio turnover within a mutual fund is the rate at which the portfolio composition changes throughout the year. It is a factor that can significantly impact the tax efficiency of a mutual fund for taxable investors.