Warning: Advising clients to buy mutual funds is a bad idea
By Don Wilkinson
DFW & Associates
Mutual funds received a little bump in 2009. Unfortunately, there aren't going to be many years like last year.
Fund investors earned returns in the range of 20 percent to 70 percent on equity and high-yield bond funds, and most didn't have to pay capital gains taxes, either. This is because funds had such big losses on the 2008 books -- gains were offset in 2009. Thus, they were able to avoid making distributions.
The millions spent on funds' marketing hype and the 2009 ROI improvement window were enough to drive millions of Americans like lemmings to the sea to continue shoveling their dollars into the fund companies' coffers.
For most mutual fund investors, the high fees, add on capital gains taxes, and blatant lack of transparency by the fund companies seem to be virtually ignored. Conversely, most investors don't even realize there are other wealth building strategies out there that are superior to mutual funds.
If you are advising your clients to buy mutual funds today, you are disregarding the tax issue at your and your clients' peril. Those losses mentioned in the third paragraph have been eliminated for the most part. By all expectations, taxes will increase in 2011.
In essence, if you are also advising your clients to hold their mutual funds for the long haul -- 10 or 20 years -- then they will pay a price down the line.
As you know, because of the way mutual funds are bought and sold, it is all too possible to lose money on your client's investment and also have them paying significant capital gains taxes. During this last year, mutual fund investors had it better. Yet, low returns and capital gains taxes -- the double whammy -- have been happening every year since 2000, and if the predictions are correct, the excess taxes will continue to punch holes in your clients' portfolios in the future.
Thus, it's my opinion that reducing your clients' taxes may be the strongest reason you have for making a separate managed account (SMA) a part of your client's wealth building strategy instead of mutual funds.
Capital gains taxes are but one explanation of why investors cannot get traction when they put their wealth into mutual funds. Many credit high mutual fund fees as another cause investors are flat-footed when it comes to mutual funds.
Here's the classic "he said, she said" scenario. The Investment Company Institute, the fund industry's trade organization, touts an overall mutual fund expense as a percent of assets at 1.17 percent.
On the other hand, KaChing, an investing and trading Web site, says mutual funds put the annual cost of actively managed stock funds at 3.37 percent. The site says ICI fails to factor in trading commissions, hidden fees and yes, taxes.
The tax liability is the biggest difference between KaChing's analysis and the ICI's position. Both organizations have a vested interest in their comments, according to a recent article (Feb 12, 2010) in the Wall Street Journal. The ICI represents the mutual fund industry, and KaChing markets investment services that compete with mutual funds.
No matter. To your clients, who are trying to save for retirement and manage their wealth, the cost of investing in funds can be enormous. Even the smallest percentage of expenses and fees can mean thousands of dollars less over decades. And the thought of more capital gains being fused with your clients' portfolio in the future is reason to pause and advise your client differently.
For instance, while a client's 2009 tax year is long gone, a great way to decrease your client's tax liability for 2010 and future years is to get him or her out of mutual funds and into a separately managed account.
You are aware that separate accounts are similar to mutual funds, but go steps further. While mutual funds invest in a number of securities for a pool of investors, an SMA further tailors a portfolio for an individual investor. Consider a separate account is like a personalized mutual fund with an assigned money manager who takes his or her cues from clients and the financial advisor, but also has full discretion to make trades as the wealth manager sees fit. The client in a separate account owns his own securities. This gives the client a level of control not available in a mutual fund.
Switching to a separately managed account will generally help reduce your client's tax burden. It can add up to a lot of money reflected in their return on investment (ROI) and be as much as 2 percent to 2.5 percent of the total annual return.
With taxable prone mutual funds recording short-term capital gains, client fund investors in the 39.6 percent federal tax bracket have to yield a performance gross of 16.56 percent to net 10 percent. But in a separate account, they would have to gross only 12.5 percent to net the same 10 percent, according to Money Management Institute, the association representing separately managed accounts.
Taxes paid by investors in taxable mutual funds currently make up about 50 percent of the $10 trillion mutual fund market. Although mutual funds have produced some pretty solid returns during 2009 (don't forget 2008), investors still seem largely unaware of the substantial gap taxes play in lagging mutual funds' returns in the markets in which they invest.
One might think that mutual fund investors getting smacked a number of times with capital gains taxes each tax year since 2000 would have them looking for a better way to accumulate wealth.
No, not unless an astute financial advisor is there to guide them in escaping mutual funds and setting up an SMA to build wealth.
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