Mutual fund investors who hold their funds in a retirement account are not affected by this aspect, since income is tax-deferred in most cases. However, if you hold mutual funds in a taxable account, which includes a substantial portion of retirees, you will be doubly surprised this year. First, you will be hit with a tax bill whether or not you sold your fund during the year. To add insult to injury, you may be responsible for a large capital gains bill despite your fund being an overall loser for the year. Second -- and few people know about this one yet -- the expiration of three year tax loss carryforwards, means that your bill be larger this year than it's been in the last five. Why? The losses sustained during the bear market of 2000-2002 enabled funds to offset gains in subsequent years. That expires this year. Lipper estimates that the average capital gains distribution is going to increase 50 percent this year (see Boston Globe).
How Did We Get Here?
Whether you are an individual or an organization, the IRS wants its cut of any income from capital gains and dividends. Mutual funds are not excluded. So, when your mutual fund manager sells positions for what you hope is a gain, that gain is taxable, regardless of whether there are offsetting losses. The same is true when a stockholding pays a dividend. For organizations that pass through these gains to the shareholders, the gains are taxable at the individual's tax rate instead of the corporate tax rate. It is prudent to pass through these gains, since a large percentage of shareholdings are in non-taxable accounts, and few individuals that are in taxable accounts are in a higher bracket than the corporate rate.
You can't fault the funds for choosing to pass through the gains. However, you can fault them for high turnover in their portfolios. In 25 years, funds have gone from an average turnover of 8 years (meaning that fifteen percent of their holdings are bought and sold in a year) to today's average turnover of 100 percent. This means that in every year, all stocks are bought and sold. Some of the most egregious offenders turn over their portfolio five times in a year. The mutual fund industry has transitioned from buy-and-hold stewards of corporate America to being short-term, rent-a-stock traders in that time. Although evidence is unclear about why this has happened, the pessimist in me believes that it is because of soft dollar arrangements resulting in an incentive to trade frequently.
Why Should I Care?
High management and expense fees have already made it difficult to outperform their benchmarks consistently. Now, if you take into account that you will have to pay a larger bill to the tax man, that just means your performance suffers even more. If you lose one percent per year to taxes, that amounts to serious money over time. Over a 30 year saving period, this difference amounts to more than 25 percent of your ending net worth. Considering that this could make the difference between you running out of money before you die, it is not to be ignored.
What You Can Do About It
Index funds do not have high turnover. The only turnover they have is periodic rebalancing when their benchmark indexes change. This makes them more tax efficient.
An even better option is to engage First Sustainable to create a so-called Folio. This combines the technology available to a mutual fund to enable you to create your own diversified, asset-allocated mutual fund. You can buy fractional shares of individual stocks. This way, your only tax bill comes when you also do periodic rebalancing to suit your financial situation. To me, this is way more acceptable than swallowing a bill that was based on some conflicted manager's financial situation.
For most of the history of the Mutual Fund Industry average annual turnover hovered around 15 to 20 percent. This means that 15-20 percent of the funds portfolio changed each year. Put another way, the average holding period for a stock in a mutual fund portfolio was 8 years. Starting in the late 1970's and accelerating in the mid-1990's, average annual turnover is now 100 percent. Put another way, the average holding period is now less than one year. So, while preaching that a steady, long term approach was appropriate for their customers, the industry has itself moved from a stock-ownership mentality to stock-rental mentality.
I am going to save for another day the discussion about how this makes it more difficult to achieve results commensurate with the enormous fees levied. Be aware that this is aspect is the biggest problem with a short-term mentality. However, there are quantifiable reasons to avoid high turnover.
How High Turnover Hurts You
I keep returning to this point. High fees and expenses are the primary reason that mutual fund performance lags their benchmarks. Some are more transparent than others:
1) Trading Commissions. This is not disclosed in the fund's expense ratio, making it harder to compare the true costs among funds. You would think that a sizable mutual fund would be able to get competitive commissions, but in actuality, many of them pay far more than any individual can get, thanks to soft dollar arrangements.
2) Taxes. If a fund manager sells a position for more than was paid, the fund is obligated to pass that through to investors. If the holding period was less than one year, the gain goes into the "short term capital gains" basket. This is taxed as ordinary income. If the holding period was more than one year, the gain goes into the "long term capital gains" basket, which has a lower rate. So, if your fund has an abundance of short term capital gains, you are paying up to 250 percent more in taxes for short term gains than long term gains.
3) Spreads. Almost all stocks have a spread. When you see a price quoted with a bid (the price at which you can sell), and the ask (the price at which you can buy). The difference is the spread. On the most liquid stock, this amounts to pennies per share. On the lower-volume and international stocks, the spreads are wider. This can amount to a serious drag.
4) Slippage. This refers to the difference between the price that was received for a buy or sell order, and the price at the time the order was given. For funds with sizable positions, you can bet that heavy buying will raise the price, and heavy selling will lower the price. Even relatively small lots of 1,000 shares will move the market in the less liquid stocks, so imagine how this affects a multi-billion dollar fund.
None of these factors are figured into the expense ratio that was quoted in the prospectus or other marketing material.
How We Got Here
Many factors contributed to the rise of speculation among the stewards of your nest egg, some understandable, some nefarious.
1) The deregulation of commissions. The 1974 rule-change dropped the bottom out of the cost of executing a trade. This made short term trading more feasible, but it also created a need for Wall Street to substitute the lost revenue. They found it. In 1970, the average daily volume was 15 million shares. In 1990, it was 300 million. In 2000, it was 3 billion.
2) The rise of IT. Computer technology enables quants (the wall street term for a manager who makes trading decisions based on computer algorithm) to plug in a vast array of data points into their systems. The result is a whole lot more buy and sell signals.
3) Captive mutual funds trading through parent-company brokerage operations. This allows fund companies to pass some vigorish on to their corporate parent without disclosing it.
4) Soft dollar arrangements. Managers are showered with perks in order to direct more volume the way of brokerage houses.
What To Do
The body of academic studies makes one thing painfully clear. There is an inverse relationship between average annual turnover and fund performance. You would have to think that otherwise bright fund companies would know this, and adjust their fund management styles accordingly. Unfortunately, I think the evidence tell us that they do know about it, but that changing their style means less in their pocket.
Mark Brandon has sinced written about articles on various topics from Best Mutual Funds. Mark Brandon is the managing partner of First Sustainable (), a registered investment advisory catering to socially responsible invest. Mark Brandon's top article generates over 3600 views. to your Favourites.