The huge distributions at ProShares and Rydex are a reminder that the old rules on cap-gains distributions must change.

(If you haven't read my articles on the distributions at ProShares and Rydex, they are available here and here.)

Capital gains distributions from mutual funds are inherently unfair. Fund companies pay out a full year's gains on a single day, and the impact on shareholders is almost arbitrary:

• If you happen to sell a fund one day before it pays a distribution, you avoid that distribution altogether;
• If you happen to buy a fund one day before it pays a distribution, you get hit with the distribution in full.

With traditional mutual funds, this situation is unfortunate but tolerable. The majority of investors hold their mutual funds for many years. Therefore, the majority of shareholders receiving a distribution will have held the fund in question during the period in which the gains accrued.

With the ProShares and Rydex inverse ETFs, however, the situation is completely different. Industry discussions suggest that the average holding period for these ETFs is somewhere around two weeks. Therefore, we can assume that the vast majority of shareholders who got hit with distributions did not hold those ETFs when the gains accrued. That's inherently unfair. The trading-oriented nature of these ETFs means the once-per-year distribution system doesn't work.

The situation is made worse by the fact that short-term capital gains distributions are treated as regular income—and not as short-term capital gains—on tax returns. It sounds like a technical distinction, yet it's anything but. If distributions were treated instead as short-term gains, there wouldn't be a problem: after all, when ETFs make distributions, their share price drops by the amount of the distribution. An investor could therefore sell their ETF, realize the capital loss and offset any distribution that way.

But under current tax law, they cannot offset the distribution in full this way. Investors are allowed to offset $3,000 of regular income with short-term capital losses, but that's the limit. If an investor receives a distribution worth more than $3,000, they will be (unfairly) stuck paying the tax man.

This should be changed. I'm not sure why the Internal Revenue Service decided that short-term capital gains distributions should count as income, and not as what they are: short-term capital gains. Either the rule should be abandoned altogether or some sort of exemption should be made for trading-oriented ETFs.

Immediately.