Perhaps you're a low-maintenance investor who doesn't like to complicate things? Alternatively, maybe you're a proponent of the permanent bull market theory, confident that the market will always rise with sufficient time? Either way, it's easy to get caught up in the convenience of mutual funds. Set it and forget it. Spend however much you want, even as little as $25 a month, and get full diversification. What's the downside (other than the possibility of prices falling, of course)? In a word: taxes.
Your mutual fund isn't static. Its manager exchanges its components all year long. Furthermore, your mutual fund probably has hundreds of components. For example, if one component gets sold and then another component gets bought, either the fund loses value (bad) or incurs a capital gain (good, but with qualifications).
That's capital gain, as in "capital gains tax." Which you have to pay, even if you don't sell your position in the mutual fund. Those taxes are levied regardless of whether you realize any increase that you can immediately derive a tangible benefit from. If you buy a single stock, you don't pay capital gains tax until you sell the stock, and even then, only if it rose in value. However, with a mutual fund, you're on the hook for capital gains tax, even if you let your fund sit.
So all things being equal, a mutual fund with little turnover will cost you less in taxes than one with high turnover. Is turnover necessarily bad? Well, only if the original components were worth holding onto.
Funds differ by any number of criteria - asset class, yield, expense ratio, volatility and tenure of the manager, to name just five. Moreover, the criterion of turnover might have the most variance of all. Take Fidelity, one of the largest mutual fund groups in existence. Even among its stock funds, with at least half a billion dollars in assets, turnover ranges from 277% (for its Focused Stock Fund, a large growth fund) to 9% for its Stock Selector All Cap Fund.
The former fund's components turn over every 19 weeks on average, and the latter, every 11 years. Adding to the confusion, the five-year returns on the two swing as wildly as their turnovers do. As of May 17, 2012, the Focused Stock Fund returned 5.36%, the Stock Selector All Cap Fund 0.41%. You can't draw conclusions about dozens of funds based on the two extreme outliers, but in our tiny sample size, it's important to remember that adding more taxable events to the mix carries with it the propensity to wipe out any gains. (On the other hand, if you prefer to look at the situation from the opposite perspective, keeping the same components year-in and year-out will result in a lower tax bill regardless of how the underlying stocks perform.)
If avoiding a high tax bill is your primary objective when shopping for a balanced investment, many of the major firms have made it relatively easy for you to do your homework. Morningstar also allows you to examine funds by turnover, as do several other sites. Turnover (and its counterpart, taxes) varies with the fund's objective and with its manager's propensity for making changes.
Are ETFs the Better Alternative?
So does this mean that you should avoid funds altogether? No. There's an entire class of funds that boast the ancillary benefit of being relatively protected against taxes. Exchange-traded funds, as distinguished from plain-vanilla mutual funds, allow wiser investors to reduce a large part of their tax obligations.
If you're unfamiliar and need a definition of "exchange-traded fund" that goes beyond the meaning of the words themselves, it's similar to a mutual fund in that it's an amalgam of multiple securities (such as stocks and bonds) that its managers sell pieces of. However, because it trades on an exchange, it is more liquid than a mutual fund and can theoretically sell from a premium or discount to the sum of its components.
Say an exchange-traded fund has some of Company X's stock in its portfolio. Almost certainly, the ETF acquired different pieces of that stock at different times – maybe it first bought some at $10 a share, and then later bought more at $20 a share. True to the form of a hypothetical example, Company X now trades at $15.
Under the right circumstances, the exchange-traded fund can then sell its interest in Company X to an investor who wants to redeem it. That investor's new shares go on the books at $20, the most recent price the exchange-traded fund paid for Company X.
From the investor's standpoint, that's a $5 loss per share. Yes, the stock had previously gained $10 a share, but those gains were never redeemed. When an ETF redeems an investor's position, the investor doesn't receive cash, but rather, shares, with no tax liability.
The Bottom Line
That all being said, there's one sure-fire way to avoid having to worry about which mutual fund comes with the lowest tax obligation. It doesn't necessarily involve exchange-traded funds, either. Just put your mutual funds in a Roth IRA or 401(k), and defer your taxes until you are at least 59.5.