Let's run through a short example to show how you can make money in a stock mutual fund.
Say you bought a stock fund in January for $10 a share. The market rose after your investment and by June the fund's net asset value or NAV had increased to $12. Note this higher share price also reflects some cash dividend payments that the underlying stocks had paid to the fund, and which the fund saved in it's cash reserves.
By September the stock market dropped. But your fund manager sold some of the fund's stock before the drop, so the fund has some internally realized gains. The fund is now worth $11 per share.
Finally, in early December, the stock market has gone back up, and the fund's price is now $13 per share. Remember this includes cash dividends received and internal gains or losses for the year.
In late December the fund is required to make distributions of its dividends received and internal gains. On a certain date, called the ex-dividend date, the fund distributes this money to shareholders.
Suppose each mutual fund share is entitled to $1 in dividend income from the underlying shares, and $1 of internally realized gains. So on the ex-dividend date, the share price of the mutual fund will go from $13 to $11, even if the overall stock market is flat.
Your fund's share price dropped $2 in an otherwise flat market, but you received $2 in distributions so you really haven't lost anything. You can either reinvest your money and buy more shares with your $2 distribution, or take it as a check for living expenses.
So for the year, you made a 30 percent return. You made $1 in dividend income, $1 in realized internal capital gains, and $1 in unrealized capital gains since the fund price moved from $10 to $11 by the end of the year.
The $2 you received in distributions are taxable, unless you hold the mutual fund in a retirement account. The $1 in dividend income is taxable as ordinary income on Schedule B of your return, and the $1 in internally realized gains goes on Schedule D.
Notice that the $1 in unrealized gains is not taxed. Changes in share price are not taxable until you actually sell the shares. This is why you may want a fund that has low dividend and capital gains distributions if you're not investing through a retirement account.
If you're investing in a taxable mutual fund, don't invest in the fund right before its distribution date. Otherwise you'll be hit immediately with a taxable distribution, and you'll wind up paying taxes on someone else's gains.
Mutual funds that have low portfolio turnover generally have low capital gains distributions. Likewise, funds that invest in growth companies that pay low dividends have low dividend distributions but a greater chance for share appreciation.
Since dividend and internally realized capital gains distributions are taxable, you may want to stick with growth stock mutual funds that have low turnover for your taxable mutual funds. Likewise, place funds that have high turnover rates and high dividend or interest payments into your retirement accounts.