There’s no doubt mutual funds remain one of the most popular investment choices. The better-known funds are fairly safe, have occasionally better returns and take a lot of the guesswork out of investing for the shareholder. In these ways, they are an alternative to the blue-chip stock for investors who want to either participate in an entire category or automatically diversify their portfolio without all the heavy lifting.
However, mutual funds are not the answer for every investor. There are some situations where having the extra bulk of a fund can work against an investor. Believe it or not, there are some financial advisors who prefer to downplay these potential disadvantages because they believe the offsetting benefits of a mutual fund can make up for the shortfall.
If you have always believed mutual funds are one of the only ways to invest, read on. There are some important things to consider before choosing a mutual fund.
One of the most important ways to moderate your tax liability with stock investing is to hold on to your unrealized gains as long as you can. With the right kinds of stock, this is a relatively easy thing to do, especially if you have a long time horizon for your investments. In fact, many investors eschew stop-loss orders on their stronger issues in order to prevent an automatic tax ding because the share price dropped below some arbitrary limit.
The problem with a mutual fund is most are required to distribute their capital gains to investors at regular intervals. Far too many mutual fund shareholders believe that by re-investing those gains, they can avoid the tax on capital gains as a result of those distributions. The problem is, those gains are collected before the new shares are purchased, which can result in tax liability depending on how the fund is managed.
This kind of “automatic gain” distribution isn’t a problem with a single issue of stock or another investment type that may be required to sell certain shares in order to improve its net asset value. For example, the stocks contained in a mutual fund could be subject to the same stop-loss orders as those some investors avoid. The only problem is if the fund manager sets those orders, there’s nothing the fund’s shareholders can do to avoid potential tax liability for the ensuing capital gains.
It should be noted some of these problems can be mitigated by capital losses generated by the exact same mechanisms, but most investors don’t put their money to work so they can collect losses. It is better to be aware of the potential for tax liability before the investment strategy is put into practice.
Some investment gurus insist mutual funds are “old tech” while exchange traded funds are the mutual fund for the 21st century. While this kind of perspective is often expressed in whimsical terms, the flexibility offered by a fund which trades like a stock presents individual investors with some rather compelling choices.
The index fund has been the darling of individual traders for quite some time, and anyone with even a passing interest in the markets didn’t have to be convinced the concept of a corporation that owns assets and offers shares to investors was practically inevitable. Getting all the diversification and/or category emphasis advantages of a mutual fund with the flexibility and cost profile of an individual stock issue provides investors with one overwhelmingly powerful incentive: cost reduction.
Exchange-traded funds have rapidly earned a reputation for being the lower cost alternative. Trading like a stock also gives them far more liquidity than a mutual fund, which only recalculates net asset value once a day. For traders interested in timing the market or trying to ride a trend, exchange-traded funds might be the better choice.
This point dovetails with the tax efficiency argument against mutual fund ownership, but it proposes a different scenario. Suppose a fund sells a particular issue at a gain but the overall fund loses value in the aggregate? Now most stock investors don’t even need to pull out their calculators to know that’s a simple case of offsetting losses against gains. Big corporations do it all the time. Right?
Not so fast.
If one of the fund’s issues is sold as a gain, it can trigger a capital gain liability for the fund investor. But if the rest of the fund’s issues lose money and simultaneously fail to produce equivalent capital losses, there’s nothing to offset. So the mutual fund investor ends up with a lower value portfolio and a tax bill.
The problem results in the way mutual fund value is calculated. It is almost the reverse of pass-through tax liability for a single-member LLC. For a mutual fund owner, selling shares of the fund may not be counted as a capital loss while selling shares of a successful stock inside the fund is. Only the taxable transactions pass through. The equivalent losses don’t.
Now some might claim this problem sounds obscure and to be fair, they have a point. In the grand scheme, it is unlikely for a successful mutual fund to bet the farm on the dark horse and then watch the rest of its five-star portfolio crash through the balcony and land in the swimming pool. That said, on the occasions when it does happen, it can be the financial equivalent of adding insult to injury.
It’s always good to get expert advice when you’re evaluating highly technical options like mutual funds and exchange traded funds. Having the right team on your side can often make all the difference. Take some time to talk to a qualified financial advisor and get a qualified opinion today. In the long run, it might be the best financial decision you could make.
*Advisory services offered through Trajan Wealth, L.L.C., an SEC-registered investment adviser.
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