How would you like to be stuck with a large tax bill this year? What if the taxable distributions were coming from a mutual fund that had horrible performance and high expenses? Many investors will be faced with all of the above as 2016 comes to an end.
Tax laws on mutual funds are old and stodgy, therefore, underlying performance and realized capital gains can become disconnected. For example, 2015 the S&P 500 was essentially flat, but many active mutual funds distributed capital gains (while still underperforming). Mutual fund managers are facing investor outflows due to high expenses and poor relative performance. Throw in a multiyear period of appreciating equity prices and you have a recipe for large capital gain distributions. Yearend performance chasing, window dressing, and manager changes have the potential to further drag down after-tax returns. Tax inefficiency has long been an odd quirk of mutual funds, but investors did not care due to economic prosperity and rising equity markets (especially during the 80’s & 90’s). Fast forward to the ‘new normal’ of zero interest rates and compressed equity/fixed income returns and mutual funds have officially been exposed.
If you’re going to own mutual funds an IRA is preferred. If you are going to own mutual funds in a taxable account, you might want to reconsider. You should also understand the total cost of investing in mutual funds (i.e. account level fee + mutual fund expense + capital gains drag = cost of investing). As investors, we should only care about net of fee and after tax returns. Unfortunately, most financial advisors do not readily offer this information.
Full disclosure: Pure Portfolios does not invest in mutual funds. Pure Portfolios will use individual stocks, bonds, and factor-based ETFs (dividend, growth/value, market cap, etc.) to express our active views on the market. We prefer low cost, tax efficient index funds/exchange traded funds (ETFs) for our passive exposure.