Rethinking Investing in Mutual Funds
Taxes take a large bite out of taxable mutual funds. Recent tax-break laws will end in 2010 and it would be smart for taxable mutual fund investors to keep an eye on one of the main drags on their performance: taxes. One key reason why mutual funds paid out such hefty taxable distributions in recent years is because they can no longer carry forward the steep losses incurred during the 2000-2002 bear market, which had been used to offset gains in recent years.
The estimated taxes paid by taxable mutual fund (MF) investors increased 42 percent from those paid in 2006, and buy-and-hold taxable MF holders surrendered a record-setting $33.8 billion in taxes to the government, surpassing 2000's record amount of $31.3 billion!
Over the past 20 years, the average investor in a taxable stock fund gave up the equivalent of between 17 percent and 44 percent of their returns to taxes. In 2006, the tax bite amounted to a hefty 1.3 percent of assets, which surpasses the average stock fund expense ratio of 1.2 percent.
Unless Congress steps up and puts mutual funds on a level playing field with other investment strategies, taxable mutual fund investors will have to fend for themselves.
Mutual funds probably have no place in high-net-worth clients’ portfolios. There are seven strong reasons in favor of this position:
You have probably noticed that every year you receive mutual fund statements with end-of-year form 1099s in their mailbox and discover a sizeable amount of your hard-earned cash going to Uncle Sam.
If you were to subtract 50 percent (93 million plus) of mutual fund holders who hold stock fund assets in tax-free accounts (such as 401(k) plans and IRAs), and a small number in institutional and trust funds that make a few investors tax-exempt, this would leave around 48 percent of the nation's mutual fund investors in taxable funds.
The SEC says the average mutual fund investor in this group loses 2.5 percent of annual returns to taxes each year, while other research puts it at 3 percent. Throughout your lifetime you can see capital gains will reduce investable income substantially when you retire.
You know the figures. Sure, during the 1980s and 1990s, people made money by selectively investing in mutual funds. Even today, it still can be done; however, when you examine the fact that more than 90 percent of mutual funds have underperformed the stock market as a whole for the past five years. You can get better odds at the horse track.
It works like this: Mutual funds with higher trading costs and built-in high tax limitations create a post-tax return that potentially delivers fewer returns than a similar separate account.
Mutual funds kill their potential for becoming performance superstars by their high volume of trading and killer fee structure. Too much trading causes increased taxes, while high fees reduce performance ROI -- period.
If you own your own stocks, this is a big difference compared with mutual funds. It means no control over which securities fund managers buy and sell; no purchases of one particular type of stock to balance out a portfolio; and no opt-out of any particular asset class or company.
On the other hand, if you put yourself in a separate account, your are the boss. Having a separate account means the client and you, the advisor, are in charge. The client and you set the strategy and decide what stocks or bonds make up the portfolio. You also have access to top money managers and can even change a manager if you wish.
The mix-and-match of separately managed accounts make SMAs attractive to the new breed of investor who wants more control and input into their portfolio. Don't you want more control after the Madoff escapade and the Wall Street blowup?
With mutual funds, you should be advised early that you do not own the stocks in the portfolio, but merely has shares of stocks along with a large pool of people. So what does your client give up when investing in mutual funds? Control.
The individual who has control of mutual funds is the fund manager. Too often, this manager is tasked with dozens or even hundreds of stocks residing in one fund. This is exactly the situation in many of the 8,000 or more funds out there on the market -- span, or lack of control.
In addition, you are tied to the whims of fund managers, who are often known to depend on "style drift" (buying securities who have no relationship to fund objectives), excessive trading (to pump up a fund's value as a means of boosting commissions), and other nefarious actions -- first uncovered by the Attorney General of New York State in 1993 and reoccurring ever since.
The mutual fund companies are good at cloaking information and spinning their marketing pitches to prevent investors from figuring out exactly what they are paying to own a mutual fund.
Space limits us to expand on all the fees your client pays for the privilege of owning mutual funds, but management fees, distribution or service fees (12b-1), expense ratios, trading costs, commissions, purchase fees, redemptions fees, exchange fees, load charges (load funds), account fees, custodial expenses, and so on, are a part of the mix that the mutual fund companies utilize to nickel and dime you to death without most of them ever knowing the billing score.
The SEC wants every investor to be fully equipped to make informed decisions beforehand. The SEC requires all corporations to disclose any and all information impacting their financial positions so investors can make prudent decisions. Transparency is most important due to the recurring events of the last 18 months.
Mutual fund companies provide notoriously slow reporting. It's most difficult to find out about all the real nuts and bolts (specific equities, bonds or cash holdings) of a mutual fund. A mutual fund gives you data twice annually -- sometimes quarterly -- which is out-of-date long before you receive it. Most investors do not read their prospectus and few fund companies know this fact. Even with the introduction of the Internet, which has sped up the tracking for securities immensely, the major fund companies have been painfully slow to keep investors current to what stocks the investors hold, and if and when those stocks are being traded.
Nowhere is the lack of transparency more apparent among fund companies than in costs and fees. Most investors are aware of management fees and commissions, but other fund fees like the12b-1 and trading fees are sublimated. Other fees are hidden, and therefore keep investors completely in the dark as to what they are paying.
With mutual funds, companies are slow on reporting results the investor seldom knows in real time what stocks are in his account and companies are known to hype performance results.
The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.
By Lance Wallach, CLU, CHFCABOUT THE AUTHOR: Lance Wallach
Abusive Tax Shelter, Listed Transaction, Reportable Transaction Expert Witness
Abusive Tax Shelter, Listed Transaction, Reportable Transaction Expert Witness
Lance Wallach, CLU, ChFC, CIMC, speaks and writes extensively about financial planning, retirement plans, and tax reduction strategies. He is an American Institute of CPA’s course developer and instructor and has authored numerous best selling books about abusive tax shelters, IRS crackdowns and attacks and other tax matters. He speaks at more than 20 national conventions annually and writes for more than 50 national publications.
Copyright Lance Wallach, CLU, CHFC
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.