Mutual fund owners might have a more unpleasant time filling this out this year. Photo by Julie Thurston Photography/Moment Editorial
Ah, the twilight of another year—time for “year that was” retrospectives, TV specials and best/worst lists. The financial world often gets in on that last one, with list after list of the year’s best and worst performing investments. Friendly advice: Those won’t do you much good—funds, sectors and countries usually trade leadership from year to year. More useful? The SEC’s Investor Advocate office’s year-end report, which highlights some products the agency found “problematic” in 2014—items that lack liquidity and transparency, like variable annuities and non-traded REITs. Coincidentally, that warning came days after a top exec at a firm with about 50% of the market share in non-traded REITs got busted for allegedly cooking the books, highlighting the perils of owning sparsely regulated illiquid products. Buried under those headlines, though, was a not-so-nice nugget about mutual funds, which are on course to give investors a not-so-nice present next year: a big tax bill. It’s another reminder that for all their benefits, mutual funds have some drawbacks, too—something to be aware of if you’re assessing whether your fund strategy really makes sense for you.
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Mutual funds are a fine way to get instant, effective diversification. Especially for folks with smaller portfolios, where diversifying with individual stocks would be less efficient and pricier. But funds’ efficiencies have their limits—particularly as it pertains to tax-related matters, like capital gains distributions, a taxable action in non-qualified investment accounts even if you didn’t sell a single share. Funds are required by law to pass through any gains realized by the fund itself to all shareholders on a per-share basis, either as a cash distribution or more shares in the fund. In other words, any time the fund manager sells any holding at a gain, for whatever reason, it’s a taxable event for fund owners. Strategy shifts are an obvious trigger, and it seems rational enough that stakeholders would have to pay the taxman on strategic transactions that fall under normal portfolio management—they’d have to do the same if they were rejiggering their own stock portfolio. But other triggers are less palatable. Like, for instance, if the fund has net redemptions that force the manager to sell shares and raise cash, and they realize gains in the process, those gains must be distributed to every fund owner, too—and taxed. So even if you didn’t sell, you have to pay because other people did.
When they can, fund managers will harvest losses to offset those gains and minimize the distribution, and many did this in the years after 2008. But nearly six years into a bull market, most crisis-era losses are all but used up. This year, reports are rolling in that mutual funds are slated to hand out big taxable distributions for the second year in a row. More than 500 funds anticipate doling out distributions of at least 10% of their net asset value—more than 60 funds expect to double that. This is a fairly big inefficiency—something for investors to weigh. In a qualified retirement account, it isn’t a big deal—you can reinvest the distributions and continue enjoying the magic of compound growth. In a taxable account, though, it can be costly. Long-term capital gains rates are typically lower than ordinary income rates, but these still eat into returns over time, limiting the amount you can reinvest for long-term growth. That’s a particularly bitter pill when those taxes were triggered by other people’s buys and sells, not tactical portfolio management.
Again, mutual funds have their time and place, particularly for smaller investors. But the larger your portfolio is, the less you benefit from a pooled structure, and the more flexibility you can gain with an individual portfolio. Mutual funds’ pooled structure makes harvesting losses for individuals darn near impossible. But a separately managed account using individual securities allows for more flexibility—not to mention more tailoring and personalization.
Stock Market Outlook
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