Mutual funds are a powerful tool for individual investors large and small. They allow for the pooling of assets so that professional money managers can be hired. They allow for simple and low-cost diversification. Mutual funds, specifically no-load funds, allow for the slow accumulation of savings. It is important to remember, however, that a mutual fund is a pass-through entity more akin to a service than a product.

Indeed, mutual funds are corporations that must pass through dividends and capital gains to those who own its shares. This allows the corporate entity to avoid taxation. Uncle Sam, however, does not allow tax revenues to disappear into the ether—if the mutual fund doesn’t pay taxes, then the shareholder must. Many people find themselves “surprised” at yearend when a mutual fund they own makes a capital gains or dividend distribution that gets included as income in some way on the tax forms due in April of the following year.

For funds with large realized capital gains, these distributions can be material. Moreover, if an investor has elected to reinvest all distributions, the money to pay for taxes must come from another source. This, effectively, means that shareholders may wind up with a higher tax liability than they expected with little way of knowing exactly what that liability will be before the end of the year.

Many fund families provide estimated year-end distribution information late in the year to shareholders either on their websites or in response to shareholder phone inquiries. Still, investors have until mid-April to come up with the cash to pay the taxes. Note that if one needs to sell securities (such as a mutual fund’s shares) to pay for the taxes on a distribution, a second taxable event may have occurred. Thus, taxes on any sales an investor makes to cover the taxes on a regular distribution must also be considered.

Another factor that often gets overlooked in distributions is the impact on share prices. Open-end mutual funds always trade at their net asset value (NAV), which is a fund’s total assets (value) divided by the number of shares outstanding. Thus, if an open-end fund pays a distribution, its share price must fall by an equal amount because supply and demand have no impact on the share price. If distributions are reinvested, the total value of a shareholder’s holdings does not change (more shares at the new lower price are added to the position).

Investors who don’t follow daily NAV quotes will probably never notice distributions, however, investors who constantly monitor their holdings could be in for a shock if not prepared. For example, the Hussman Funds paid their required annual capital gains distributions on November 19th. As a shareholder who watches daily NAVs, I was a bit taken aback by the 4%+ drop in the value of Hussman Strategic Total Return Fund (HSTRX) that was reported by my favorite quotation site because fund distributions are not incorporated into the raw quotation. Such a large move is out of the ordinary for this fund. However, knowing it was the end of the year, I quickly went to the fund family’s web site and noted the distribution of $0.5381 per share ($0.3631 characterized as short-term and $0.1750 as long-term) prominently reported on the site. For investors not versed in the impact of distributions, seeing a 4% drop in a fund that normally moves in much smaller increments could cause some palpitations.

Although simply a regular event, fund distributions can have material impacts on shareholders. As the end of the year nears, and with it annual distribution dates, an ounce of knowledge can go a long way.

At the time of this articles writing, the author had a position in Hussman Strategic Total Return Fund (HSTRX).