Seven big reasons to drop mutual funds from your clients' portfolio
By Don Wilkinson
DFW & Associates
As a financial advisor, you should always be looking out for the best interests of your clients. I'm here to tell you, it doesn't come through stacking their portfolios with mutual funds.
Yes, there is a place for mutual funds for clients who have modest funds to invest, but to advise high-net-worth clients to invest in mutual funds is a gross injustice to those highly desirable individuals -- and to your practice. If you wish to position yourself as a true wealth manager, you have to wean yourself off of mutual funds and present these wealthy clients with more sophisticated asset management strategies, like exchange traded funds (ETFs) and the highlight of this article: separately managed accounts (SMAs).
There are seven strong reasons why:
1. Taxes: Tax pain or less tax gain As an advisor, you have probably noticed that every year, your mutual fund clients are sent scrambling when they receive their end-of-year form 1099s in their mailbox and discover a sizeable amount of their 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 a client's lifetime, most advisors can see capital gains will reduce investable income substantially when their clients reach retirement.
A much better strategy would be to put your clients into a separately managed account. Remember, skilled trading -- not excessive trading -- keeps costs low. Excessive trading (a real issue with mutual funds) saps after-tax returns in mutual funds. By putting your client in a separate account, excessive trading that causes bounce-back tax bills will no longer be a concern. Your client owns the stocks in his/her portfolio, and the advisor is in sync with the money manager, who can sell underperforming stocks on a systematic basis to offset capital gains.
Remember that, as a rule of thumb, if the IRS took more than $10,000 from your client during the last tax year, he or she would probably benefit from the tax efficiency of a separate account.
2. Performance: Questionable returns or unquestionable better returns
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, this is a no-brainer. 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 (see No. 6). Too much trading causes increased taxes, while high fees reduce performance ROI -- period.
3. Customization: Off-the-rack or tailor made
If you ride a Greyhound bus, you will reach your destination eventually, but not before dealing with 10 stops and putting up with kids with runny noses. Wouldn't you rather ride in your own limo with a personal driver and no stops or hassles along the way?
Investing in mutual funds is like traveling on Greyhound. You are thrown in with other investors who are more neurotic about investing than you are. You are subject to the whims of the other investors and the fund manager. With a separate account, control of your journey is left to the client and advisor.
If your client owns his/her 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 your client in a separate account, he or she is 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 his/her portfolio. Don't your clients want more control after the Madoff escapade and the Wall Street blowup?
4. Asset control: Manager or investor in control?
With mutual funds, your client should be advised early that he or she does 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, your client is cuffed 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.
With a separate account, your client will be limited to approximately 30 to 80 securities, supervised constantly and consistently by professional money manager(s). Your client suffers no impact from other investors' actions and most importantly, is in more control of his portfolio.
5. Prestige factor: Invest with the rest or invest with the best
Never underestimate snob appeal. Many older Americans who were weaned on mutual funds are comfortable with the investment process that has been around for some 60 years. But today's investors are more comfortable with change. Those with "emerging affluence" are asking themselves if they should stay with the ultimate retail investment -- one that is associated with mass market investing and that is now viewed by many as a commodity.
In other words, a private money manager servicing your separate account alongside a Ford Foundation or a Bill Gates provides a prestige factor that is hard to ignore.
Separate account investors receive asset management guidance on an individual basis and custom solutions for securities they own. Bill Gates gets the same treatment.
6. Fees: Larger hidden fees or flat fees
Mutual fund fees are fast increasing, and did I mention that mutual fund returns are decreasing?
If a tire company raises prices on a set of tires, barring inflation, you'd expect a better tire, a better warranty, a better something -- not a tire that blows out easier than before. Higher prices shouldn't make for a shoddier product.
Tell that to the mutual fund companies. Performance is lower, while your price for that performance is higher. Does that make any sense?
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 you should be conveying to them that 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 your client to death without most of them ever knowing the billing score.
In a separate account, your client pays one flat fee for all services rendered. It's out in the open, not hidden in microprint of the prospectus.
If you want to truly serve your client, consider setting them up in a separate account. In a separate account, one annual payment covers management fees, trading costs and incidentals. Further, it includes fees for you and the money manager(s). All other administrative functions to service the accounts for the client are included.
The fee ranges between 1 percent and 3 percent of assets. Why the large spread? Separate account fees are based on a sliding scale. The more money your client initially puts in the pot, the lower the fee percentage. With mutual funds, the annual expenses remain constant, no matter how much cash is invested. The separate account offers a much clearer, less deceptive form of fee structure.
7. Transparency: Delayed reporting or near real-time reporting
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 -- and you should do the same for your clients' sake. Transparency is most important due to the recurring events of the last 18 months.
Unfortunately, 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.
Contrast the transparency of mutual funds with separate account holders, who can review their accounts on a daily basis. Their stock performance review is readily available on close to a real-time basis. Fees are a known entity.
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.
With separate accounts, a client can receive account information is almost real time -- reporting quarterly, monthly and even daily trades -- and the client can hold advisor and money manager(s) accountable.
For many years, mutual funds were the major investment solution in which financial advisors could offer their clients sufficient diversity, costs and returns.
Today, the asset management landscape has changed. With the advent of technology, exposed fraud and abuse within the fund industry, and new investment alternatives being offered by Wall Street to investors, clients can now receive a better shake. Many of these newer financial strategies can offer benefits much superior to mutual funds. SMAs are evolving, making a superior financial strategy even better. A unified managed account (UMA) is a professionally managed private investment account that is rebalanced regularly, and can encompass every investment vehicle (e.g. mutual funds, stocks, bonds and exchange traded funds) in an investor's portfolio -- all in a single account. This is an important issue with the baby boomer generation, who wants its financial portfolios simple and uncomplicated.
With managed accounts -- either SMAs or UMAs -- your client can level the playing field and have you develop a portfolio that grows their wealth and makes sense for that particular client, with a reasonable fee structure, potential higher performance returns, reduced or non-existent capital gains taxes, full client control, customized portfolio and clean transparency.
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