Embedded capital gains are unrealized gains in a mutual fund that are eventually passed to investors when the securities are sold. The net effect on clients is they may receive these taxable distributions on gains they did not participate in or realize. These capital gains are "embedded" because they are not realized or taxed until the shares of the mutual fund are sold.

When a mutual fund manager sells a security at a profit, that profit is considered a capital gain for all shareholders, regardless if the mutual fund shareholder benefited from the gain or not. All shareholders still need to pay taxes on the gain made from the original date and price the securities were purchased by the mutual fund manager to the selling date and price. The mutual fund then may distribute a portion of these capital gains to shareholders as a capital gain distribution. This distribution is also taxed as ordinary income, regardless of whether the investor held the mutual fund shares for a short or long period of time.

For example, if a mutual fund manager bought a stock for $10 and later sells it for $15, the fund has an embedded capital gain of $5. If the fund distributes this gain to shareholders, it will be taxed as ordinary income, regardless of how long the investor held the shares or if it results in a profit for the shareholder.

Embedded capital gains can be a disadvantage for mutual fund investors because they can trigger a large tax bill without the gain, even if the investor has not sold their shares. Additionally, capital gain distributions can cause a mutual fund's net asset value (NAV) to decrease, which can negatively impact the fund's overall performance.

It's important to note that some mutual funds have a higher potential for embedded capital gains. This could be because the fund has had a high turnover rate or because it has a significant portion of its portfolio invested in securities that have appreciated in value.