Every year—usually in December—an event occurs that causes confusion and frustration for many mutual fund investors and their tax advisors.

If you are holding mutual fund positions at some point this month you might be surprised by a sharp drop in the price or NAV of some of those funds. It could show up as a pretty dramatic drop of 10% or more in a single day. But while the price of the fund shows a dramatic drop, the account value will not decline. That is because of a phantom distribution that takes place with most mutual funds during December.

The distribution is calculated into the net asset value (NAV) of the fund and you simply end up owning more shares at a lower price. The account value never changes.

Let’s say you own 10 shares of XYZ Fund and on December 18, those shares were valued at $10 each. During the year, the fund accumulated dividends, yields and distributions equal to 10% of the fund’s total value. In reality, this dividend income has been included in the price of the fund all year long. But on December 19, the fund passes these earnings on to you as a phantom distribution. So while your account value on December 19 is the same total of $100 as it was on December 18, instead of owning 10 shares valued at $10 each you now own 11 shares valued at $9.09 each.

For accounting purposes, this distribution of dividends shows up as investment income paid to you. (And that is how the IRS views it if your mutual funds are not held in a qualified account like an IRA.) That means that if you hold the fund in a taxable account, you will be required to pay taxes on the distribution.

Unfortunately, there is no sure way to know ahead of time how much the distribution will be or even exactly when it will be recorded. As a general rule, funds that have a high turnover ratio have larger distributions. And most funds record that distribution at about the same time each year.

No Santa Claus rally yet

Investors waiting for a December market advance (often referred to as the Santa Claus rally) are disappointed. For the past month, stocks have traded in a fairly tight range and so far there is no indication of a change in that pattern.

Below is a candlestick chart of the New York Stock Exchange composite over the past three months. (For an explanation of this type of chart, check this link: http://en.wikipedia.org/wiki/Candlestick_chart)

I added the light blue box to highlight the tight trading range that has dominated for the past month. For that period, stocks have generally been trendless. Only once in that period have stocks moved in the same direction for three consecutive sessions.

The relative strength index (RSI) on the bottom portion of the chart shows a pattern of failing strength. That is normally not a good sign and it indicates a possibility that when this tight trading pattern is broken, a sharp downturn could occur.

As we have been saying for several months, while stocks currently remain in an intermediate upward trend, risk remains high and investors need to remain cautious.

F.S.