Even in a so-so year, mutual funds are a bad investment for your clients

By Don Wilkinson

DFW & Associates


Another year is about gone and it’s business as usual for mutual funds — they will short-change millions of American investors as the year draws to a close.

Unlike 2008, when mutual fund investors had losses approaching 40 percent, 2010 is different because mutual funds did get a bump, especially in the second quarter, keeping them in the running as America’s favorite investment. Funds will probably average returns of around 10 percent, according to Tom Roseen, senior research analyst at Lipper. Capital gains will be low too, particularly in the lower income tax brackets, due to the huge losses incurred in 2008 being carried over.

Even if there’s an upswing this year, can you still argue against investing in mutual funds? You bet you can. A huge number of American investors are in mutual funds, and most are unaware of other financial strategies that would offer a better wealth building experience.

Knowing that history does repeat itself, mutual funds will certainly continue with unnecessarily high fees (visual and hidden), high add on capital gains taxes and a blatant lack of transparency by the fund companies. Financial advisers and investors alike for the most part ignore this downside of funds across the fruited plain.

In spite of a down economy, shrinking 401(k)s, and a dismal employment picture, American investors continue to invest in mutual funds, often influenced by their financial advisers, who should know of better asset management sources to preserve and increase their clients’ net worth.

If you are advising your clients to buy mutual funds today, you are disregarding the tax issue at your clients' peril. Capital gains might be minimized this year but what about next year and the year after that? By all expectations, taxes will increase in 2011 unless the present Congress extends the Bush tax cuts. This should be a given considering the result of the mid-term elections, but don’t hold your breath.

Nevertheless, if you are 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 with 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 occurred each year since 2000. And, if my predictions are correct, excess taxes will continue to punch holes in your clients' portfolios in the future.

Capital gains taxes are one of the biggest reasons investors should not be in mutual funds. Running a close second are low returns and high fees — open and hidden — that cause investors’ return on investment to bottom out after a taxable year.
As a financial adviser, you should know fund returns have been on a roller coaster since 2000. This made most of the following years a double whammy for investors who received increased taxes and unanticipated lower returns most Januarys over the decade. It’s called the “January surprise.”

Although capital gains distributions are not expected to be as great this year as in past years, the taxes paid now will either reduce the tax you owe when you sell your fund shares at a gain, or increase your loss for tax purposes. Your goal should not be to pay taxes sooner than later, as it robs a portfolio of the benefits of compound interest.

In spite of the millions spent on marketing hype by fund companies and brokerages trying to convince you that selling mutual funds is the best way to build wealth, it isn't necessarily so. There are much better returns-generating vehicles that are more secure, more transparent financial strategies such as exchange traded funds (ETFs), index funds, and what we recommend: separate managed accounts (SMAs) that put the genie in your corner and more dollars in your clients' pockets.

Thus, it's my opinion that reducing your clients' taxes may be the strongest reason you have for making a separate managed account a part of your client's wealth building strategy instead of mutual funds in 2011.

You are aware that separate accounts are similar to mutual funds, but go steps further. Mutual funds invest in a number of securities for a pool of investors, and SMAs customize a portfolio for an individual investor.

Consider a separate account like a personalized mutual fund with an assigned money manager who takes his or her cues from clients and the financial adviser, but also has full discretion to make trades as the wealth manger 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.

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 and this year (don’t forget 2008), investors still seem largely unaware of the substantial gap taxes play in lagging mutual funds returns in the market in which they invest.

One might think that getting smacked a number of times with capital gains taxes since 2000 would have mutual fund investors looking for a better way to accumulate wealth. No, not unless an astute financial adviser is there to guide them in escaping mutual funds and setting up an SMA to build wealth.

Since 2005, we have been urging advisers and investors alike to set up a separate managed account. Advisers should have this knowledge base to best inform their prospects and clients on a wealth building strategy that's better than mutual funds.