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Exploring the Hidden Tax Consequences of Mutual Funds

By: Ryan Fulmer
Thursday, March 1, 2012

One popular investment strategy for investors is to invest in stock and bond mutual funds.  Whether passively or actively managed, the fund industry, as a whole, has grown considerably over the last decade.  For an individual who is in the process of building his or her wealth, this strategy can be a prudent and efficient means for building a nest egg.  However, once an individual becomes more well off, there are less-costly tax-efficient solutions to creating wealth that exist--particularly separately-managed accounts.  In this article I will explore the tax implications of several of the most popular indexing strategies.  I will discuss how and why capital gains accrue in index strategies and why a separately-managed account is a superior route to growing and preserving your wealth.

How do capital gains accrue in mutual funds?

If you have a portfolio of stocks and bonds, dividends and interest accrue throughout the year.  These tax burdens occur whether or not you are invested in a mutual fund or a separately-managed account.  However, there are a few reasons mutual funds create excessive tax burdens for an investor when compared to taking the separately-managed account route.  When investors in mutual funds redeem their shares, or money flows out of the mutual fund, the fund’s portfolio manager needs to sell securities in order to raise enough cash to meet the redemptions.  Additionally, if performance sours, or a style becomes less in favor, the fund may need to sell considerable amounts of its holdings, creating an unnecessary tax liability on the investors in that fund.  For most investors, though, the most common way in which capital gains are created occurs when the manager of a fund turns over the positions in the fund.  Portfolio turnover is the percentage of your portfolio that is new each year.  In many actively-managed mutual funds, portfolio turnover can be over 100% a year.  This means that an investor in that fund can acquire (regardless of his intention) a completely new portfolio of stocks each year!  Even in passively-managed mutual funds, which simply use indexing strategies, the tax implications may surprise you.  We analyzed two popular funds which had a turnover of approximately 10% of their portfolios every year.  Since our separately-managed accounts are built specifically for each client, a large amount of the unnecessary portfolio turnover and tax liability is reduced.

How does inefficiently managing taxes affect long-term investment performance?

At this point you might be saying to yourself, “Okay, this seems rational, but can I see how embedded tax liabilities in mutual funds affect performance?”

Over the past few weeks, Beese Fulmer has been analyzing a couple of the most popular passively-managed funds which employ indexing strategies.  Specifically, we analyzed the iShares S&P 500 Stock Index Fund (SPY), the largest exchange-traded fund (ETF) with over $99 billion in assets under management, and the Fidelity Spartan 500 Mutual Fund, which also tracks the S&P 500 and currently has $45 billion in assets under management.  Our logic in choosing these two funds is that, considering their size and firm stature,  they are probably two likely equity fund choices for the average high-net-worth investor.

At the conclusion of our analysis, we found that the embedded tax liability for these two strategies was quite significant.  In the following chart, we compare 5 and 15-year annualized returns.

Over the last 15 years, the annualized return for the S&P 500 has been 5.58%.  When comparing the two indexing strategies, both performed in line with the S&P 500 before adjusting for taxes.  Unfortunately, taxes significantly reduced the benefit of investing in such “low-expense” equity options.  The impact on investment returns for the Fidelity mutual fund and the iShares ETF reduces the returns by 12.6 and 8 percentage points, respectively, to 4.77% and 5.03% versus 5.58% for the S&P 500.  Indexing is misleading, as the low-average expense ratio of 8 basis points is inexpensive and, at first glance, seems like a reasonable alternative to the cost of separately-managed accounts.  However, when the unmanageable impact of taxes is included with the total cost of these solutions, the cost increases to about 49 to 79 basis points.

How are separately-managed accounts a more prudent strategy for wealthy individuals?

Hopefully at this point you are wondering how Beese Fulmer, through separately-managed accounts, can manage taxes more efficiently.  As your account’s portfolio manager, Beese Fulmer works with you in such a manner that limits the tax burden on the account.  How do we do this?  We take a comprehensive view of your financial picture.  We work with your accountant to determine when capital gains should be taken, and we work with your estate attorney to determine which securities are most appropriate for generational and charitable planning.  Additionally, we analyze individual tax lots to minimize capital gains, while working to provide you the best portfolio possible.  Perhaps the most important way in which we manage taxes in your account, however, is through our investment philosophy.  Since we invest rationally and in high-quality franchises for the long term--while taking a comprehensive view of your wealth--our strategy naturally leads itself to be more tax efficient. 




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