On the surface, mutual funds seem to present an easy, hands-off option for investors. This ease can mask some undesirable features, like tax complexity, about which investors may be unaware. Is there a better way to gain desired market exposures?
Watch this 30-minute video to find out Blue Chip Partners' perspective on mutual funds, hosted by Robert Steinberg, Daniel Seder, and Matt Mondoux. Topics covered include:
Septembr 26, 2022 at 4:00 P.M. E.T.
Matthew Mondoux 00:07
I want to welcome and thank everybody for attending today's Blue Chip Partners webinar. This is more of our educational variety. We want to describe what goes on with mutual funds, what you see, what you don't see, and what you really need to know. Before we jump into that, I want to cover a couple of minor housekeeping items. Two main things here: if you don't follow Blue Chip Partners on LinkedIn, I definitely would suggest connecting. We post regularly, a lot of market commentary, thoughts, things that are timely and we find interesting that we want to share. Also, I would direct you to go to the Blue Chip Partners website at the top, where there's an Education tab. From there, you can get right to our blog, where we're doing a lot of the same posts as LinkedIn. We're trying to get out as much content as we can through different avenues. I would encourage everybody to put those two things on their radar as ways to see the latest and greatest insights by not only the financial planners but also the investment committee here at Blue Chip Partners. Also be on the look-out for the Quarterly Edge in your e-mail inbox. We'll also have an associated video that will get released with that, highlighting some of the more pertinent points of the couple-page commentary there. With that, we'll jump into the meat of the presentation today: mutual funds, what you don't know can hurt you. Today's presenters will be Robert, myself, and Dan. I'm going to kick us off with understanding funds and fund expenses. Robert will go through capital gains distributions, and then Dan will describe a stock intersection, which is pretty interesting how various mutual funds complement or don't complement one another.
Matthew Mondoux 02:50
Alright, so understanding fund expenses. What we've tried to create here is a hypothetical mutual fund portfolio. This is something we commonly see, deal with, and understand. It's kind of the other side of the business - when you're not doing in-house Investment Management. This is how a large cohort of financial professionals manage money for clients. In essence, in a lot of ways, it's farming out the management to a third party, which isn't bad or good. It just has its costs. Without knowing the full extent of what those costs are, a lot of investors can potentially be leaving money on the table through unneeded expenses. So again, a typical portfolio here that we might see is a couple of US large-cap funds, a small-cap fund, an international, and some bonds. This would actually be a fairly pared-down portfolio from what we commonly see, at only about eight positions. This can be anywhere between eight to 20 different mutual funds in some cases. As part of a disciplined asset allocation, this portfolio's case is about 60% stock / 40% bond. Each mutual fund is allocated to a certain piece of the portfolio, which you see highlighted in blue. The column to the right designates the expense ratio for each fund that's held in that model.
Expense ratios you can think of are Colombia's fee or the American Fund's fee for managing the money. They obviously put time, energy, and marketing into managing a fund, so they're going to be compensated. Generally speaking, an advisor using that fund would think, "Okay, well, that's worth it, and I don't have to manage the portfolio. Columbia will do it for me, and their expense ratio is worth it."
To understand what this portfolio might cost, we need to take the allocation percentage and multiply it by that expense ratio to get a weighted expense within the portfolio; we've done that in the third column in the green. What we've done is we've calculated by simply multiplying the allocations by the expense ratio for the weighted expense. Then we sum those weighted expenses across the whole allotment of mutual funds to get that total mutual fund expense. This is a fee completely separate from an advisory fee. Advisory fees are often very explicit, you know, what you pay the advisor who you're working with. This layer of fees is baked in, and it's really not explicit. It's hidden within the fund. You never see it come out on a statement, but it does exist. You just have to do a little digging to figure out what that expense is. So, like I said, not all expenses are bad. They're not all created equal, but it's worth knowing how to get this information for yourself should you come across a mutual fund portfolio like this. I would even add in 401Ks, which almost exclusively offer mutual funds solely as their investment choices; every one of the mutual funds within that 401K or 403B retirement plan is going to have an expense ratio. It's just an extra layer of due diligence. When you think about fully analyzing your portfolio, that's really important to understand. With that being said, I'll pass it over to Robert. Robert is going to talk about another hidden part of mutual funds, very timely for this time of year. Robert, without further ado.
Robert Steinberg 06:31
Thank you, Matt. When we look at mutual funds, we forget that there's another layer of expenses when we're working with advisors. One of the most significant downsides of investing in mutual funds in non-retirement accounts is that they are required to make annual distributions of virtually all capital gains recognized by the fund during that year. If you own a mutual fund in a retirement account, capital gains are non-events since taxes are only owed when a distribution is taken from the retirement account.
The purpose of my discussion is to talk about capital gain distributions held in non-retirement accounts. It's natural to think of capital gains distributions as a good thing - the fund made money, and I'm getting my share of the profits. If you own a mutual fund in a non-retirement account, in almost all circumstances you would prefer not to receive a capital gain distribution. Why this is the case has to do with how capital gain distributions work. When a capital gain distribution is made, the fund's price will drop by the percentage of the distribution. If a fund makes a 10% capital gain distribution, the fund's price will drop by 10%. This occurs because a distribution has been paid to you. If you reinvest your capital gain distribution (as almost all investors do), at the end of the day, you will own more shares, but the dollar value of your investment will not change. Assuming dividend reinvestment, if your mutual fund investment was worth $100,000 before the distribution, it would be worth $100,000 after the distribution. The unwelcome news is that you owe taxes on the amount of that distribution, even if you reinvest the dividends. Think of a pizza being cut into ten pieces rather than eight pieces, but the tax man takes a couple bites out of the pizza. This is why mutual fund capital gain distributions in non-retirement accounts are not a good thing.
I wish that was the end of it. The worst thing about capital gain distributions is they are calculated at the fund level, and have no relation to the performance experienced by the individual investor, you. For example, an equity fund that sells Tesla stock in 2022 after owning it for 10 years will have a significant capital gain. The gain distributed would be the difference between what the fund originally paid for Tesla, and the value of Tesla when it was sold. If you first became an investor in the fund in 2022, you will be taxed on the full amount of the gain, just like the investor who has owned the fund for 10 years. Mutual funds do not keep track of when individuals come and go. All shareholders of the fund on the record date will get a distribution of the capital gain based on their percentage of ownership of the fund.
I wanted to review three examples that will help you better understand mutual fund capital gain distributions, and how, in certain circumstances, you may want to take action to prevent unnecessary taxes. I'm going to use the example of the ABC Fund, which trades at $100 and is going to make a 10% capital gain distribution. After the distribution, the price per share will drop to $90, and the record date for the distribution will be December 3.
Let's first focus on Larry, which is the easiest example. Larry bought the fund five years ago, his tax basis is $50,000, and the fund is worth $100,000. Larry has a $50,000 gain. From a tax perspective, when the gain from selling the fund is greater than the amount of the capital gain distribution, it is better to receive the distribution. From Larry's perspective, if he sold the fund in order to avoid the capital gain distribution, he'd have a gain of $50,000. By receiving the distribution, he's only going to have a gain of $10,000. Assuming Larry would reinvest the $10,000, at the end of the day, his tax basis would go from $50,000 to $60,000, and his invested value in the fund would continue to be $100,000.
Our second investor is Mo, and Mo isn't too sharp. He actually invested $100,000 in the ABC fund on December 1, 2022, and his fund is currently valued at $100,000. He has made no money. Hopefully, Mo did this on his own, not with the help of an advisor. Mo’s problem is the fund is going to pay a 10% capital gain distribution two days after he bought it. If Mo does nothing, he's going to receive a $10,000 capital gain distribution, even though he has made no money. He will have to pay tax on that distribution. If he does not sell the fund prior to the distribution, and reinvest the distribution, his basis will go to $110,000, but his value will still be $100,000. He's going to end up paying taxes on a $10,000 distribution when he has made no money. I draw the analogy: it's like getting a ticket for driving the speed limit.
The third circumstance, which really is the one that we want to focus on, is Curly. Curly invested $120,000 in the ABC fund in January of 2022. Due to the declining stock market, his value is now down to $100,000. So, Curly has actually lost $20,000. His case is a particular concern because if he does nothing, he will also receive a $10,000 capital gain distribution. He will be paying tax on his investment in the ABC fund, even though he's lost $20,000. It's really, really important in this circumstance that Curly sells the fund prior to receiving the capital gain distribution. In this case, he'll recognize a $20,000 loss that he can use to offset other capital gains that he would incur. If he does nothing, he's going to end up receiving a $10,000 capital gain distribution, and he will owe tax on that distribution. If he reinvests that distribution, his tax basis will now be $130,000 (the original $120,000 plus $10,000), and his value will only be $100,000.
With the market declines and so many funds experiencing significant outflows, we're anticipating larger capital gain distributions in 2022 than we've seen in prior years. How do you figure out what the distribution will be? Mutual fund companies will publish this information on their website, but they really don't go out of their way to let you know what's happening, so you'll have to do a little bit of research. They generally provide a range of anticipated distributions. For example, between 5% and 7%, or 8% to 10%. They don't give you the precise amount and the amount will vary by fund. The important thing is to evaluate each stock fund that you own in a non-retirement account. Again, distributions in retirement accounts are not a concern. If you're in a circumstance where the capital gain distribution is greater than the gain you would recognize selling the fund, it makes sense to sell the fund prior to receiving the distribution. In closing, do the necessary research or reach out to your financial advisor to make sure you don't get caught paying taxes that could have been avoided.
With that, I'll turn it over to Dan to talk a little bit more about the mutual fund intersection.
Dan Seder 14:58
Thanks, Robert. Thanks, Matt. Thank you everyone for listening. And as I continue on the discussion, it is really common for us to have a prospective client come into our office and present their statement. And like Matt mentioned, you know, there could be eight mutual funds or there could be 25 different mutual funds of all different flavors. You end up seeing large cap funds that come in the various flavors of growth and value, you have mid cap and small cap, which are smaller companies, international emerging markets, bonds, the entire gamut. I think the challenge when we see this is that these portfolios, in many ways, become over diversified. And when you look at what's underneath the hood, the average mutual fund can have upwards of 150 different individual securities. And so when you think about that number, and you multiply it by, I don't know, 10, 15 or 20 different mutual funds, you end up in a sense, owning the entire market, owning a little bit of everything. So, I equate it to going to the horse race and betting on every single horse; Robert likes to call it going to the roulette table and putting chips on every single number. I think at the end of the day, you spread yourself so thin, across the entire spectrum of the investable universe, you've diluted away any chance for outperformance. In a sense, you get the average because you've invested in everything, minus those big fees that Matt described. And, you know, potentially putting yourself in a tax trap that Robert talked about.
Not all mutual funds are bad. Again, they're important in a variety of different segments of a portfolio at different times. What I want to focus on are two of what I consider the main unintended consequences of owning a mutual fund, which is concentration in a particular security and the lack of coordination amongst the managers.
What we have on the screen here right now is what's called a stock intersection report. We took the three domestic U.S. large-cap mutual funds that were in Matt's mock portfolio, and we scanned through to say, of those three large-cap U.S. funds, what are the underlying holdings? What individual stocks do those mutual funds own underneath the hood? The number one holding in this portfolio is Microsoft. You can see that each fund (Columbia, American funds, and Fidelity) owns Microsoft. The second largest fund or stock position is Apple, and the third is Google. What you'll notice, and we're only showing you the top three, but if I went through the top 50, which is pages of results, all of these funds own a lot of the same individual securities. The risk of what we call unintended concentration is, what if these portfolio managers decide to invest more heavily in Microsoft? Or, what if they all decide collectively to invest more heavily in Apple? You, as an investor, see a diversified portfolio of different names (Columbia, American Funds, Fidelity), but yet underneath the hood, there is a potential that these money managers could be pushing some of their fund towards a particular stock or two, putting you at risk of not being as diversified as you thought. I think that stock intersection report is really valuable when you're looking at equity mutual funds, and we run this analysis all the time to see what's underneath the hood.
The second risk is lack of coordination. When you consider two mutual funds, you have mutual fund A and mutual fund B, and for all intents and purposes, (this is hypothetical) let's call mutual fund A “Fidelity” and mutual fund B “Columbia.” If the Fidelity fund owns Apple, and wants to sell Apple to buy Microsoft, what can happen is the Columbia fund can own Microsoft and want to sell Microsoft to buy Apple. The net effect of this crossover ends up leaving, potentially leaving you as the investor in a neutral stance. We think of it as a relatively inefficient form of management. There are layers of individuals involved that make it more complex and more costly, and at the end of the day, we think it's more inefficient, or less efficient. The difference between what I'm describing here on the screen and what we do at Blue Chip Partners is we act as the money manager, and we're making the single stock decisions to buy Apple, or to buy Microsoft, or to buy Google. There isn't a crossover. It's very plain, pure, and direct. So with that, before I open it up to Q&A, I just wanted to remind everyone, as Matt mentioned at the beginning, if you wouldn't mind, please like us on LinkedIn. Follow us and check out our blog. I wanted to point out that everything that we do on the blog is original content from us. We're not repackaging something from some kind of research or white paper that someone else wrote. It's all original content, and we hope you enjoy it. With that said, what I'll do is open up the lines. Antone, I guess we would rely on you if there's any questions that came through the chat box.
Antone Lamerato 21:11
I don't see any questions yet. Everybody, you're more than welcome to go ahead and click that chat tab up at the top and enter any questions you may have. In the meantime, though, Dan, I think you have some other stuff to touch on.
Dan Seder 21:23
Yeah, actually, I had a question. I have a question for Matt. Matt, if you wouldn't mind, I hear the term "no-load mutual fund" often. Can you maybe just shed some light on what it means to have a no-load mutual fund, and the difference between a load and that term, a load in investing, and then these ongoing fees that are getting charged by mutual funds?
Matthew Mondoux 21:50
Gosh, Dan, you're really dating me here. These things are probably more from long ago. It seems like most load mutual funds are few and far between now. It's essentially paying a commission upfront for either a reduced or no fee from there on. However, the commission upfront can be relatively large; a few percent, and obviously the advisor would share in that compensation, as would the mutual fund company. More infrequently now, you really do want to look out for institutional share classes, those end up being the most cost effective solution. That's the whole other side that I could have actually incorporated. You'd be amazed, one mutual fund (Fidelity Contrafund) may have six different share classes, all of which can mean something different, and all of which can have a separate fee. There's this whole other side of the industry that I think would be truly surprising. One share class could be a commission-based share class, one can be the institutional, and one could be in a mutual fund. It's pretty complex. Generally speaking, it's always in your best interest to take that five-letter ticker and type it into Google or Yahoo Finance and do a little due diligence to figure out what that expense ratio is because they do need to explicitly state that on their website. Oftentimes, some of these kinds of financial aggregation will also have that data.
Dan Seder 23:28
Okay, and Matt, I wasn't trying to date you there, but what I guess I was trying to draw on, I think you basically said it, is just because something is no-load doesn't necessarily mean that it's no cost, right? So you could trade into a mutual fund, potentially with no-load, but that doesn't mean you are exempt from ongoing expenses that you may be hit with every year.
Matthew Mondoux 23:57
Antone Lamerato 23:58
We did get a question come through. It is, “What vehicles do you implement at BCP? Individual securities directly? ETFs? Or are you just more mindful about the mutual funds you're using?”
Dan Seder 24:11
That's great. Maybe I'll take the first stab, and then we can pass it along. Primarily in the stock component of our portfolio, clients will generally have a component of stocks and a component of bonds, or equities and fixed income. In the equity component, for the most part, we're using individual securities, companies that are satisfying certain criteria, names that you would recognize if you saw on an investment statement. Periodically, we'll blend in an ETF, which is an exchange-traded fund, into a sector that may be relatively small - in something like the S&P 500, or the Dow Jones. Outside of the United States, for equities that are overseas, we're generally using some type of mutual fund that we have high conviction in the manager, and it has a reasonable cost structure. As I think both Matt and I mentioned, it's not that we don't use any mutual funds. We certainly try to limit the use of products whenever possible. Now, on the bond side of the portfolio, the fixed income component, that's where we generally use low cost mutual funds and exchange traded funds, and that's for a variety of reasons. The bond market... Matt, maybe you can touch on why that's important in the bond market.
Matthew Mondoux 25:37
Yeah, I mean, that's pretty key. The bond market really tends to be difficult to diversify at scale. I guess the analogy that was always put forth to me is, there's a reason why bond traders drive Ferraris - they're constantly making money off every transaction. They're taking a cut and there's not as much price transparency as there is if you buy and sell a share of Apple. We can clearly see what it's trading at, what the bid and ask is; generally, the difference between what somebody's willing to buy and sell is a penny, at most. Bonds could be dollars, hundreds of dollars. It's really tough to know. They don't trade as frequently and there are so many issues. It can be a lot more cost effective, actually, to pay up a marginal fee or a minor federal bond manager. You get diversification, that is transacting at scale in a way. That's really tough to do, and they're getting better pricing. For that, some reasonable fee can be appropriate.
Dan Seder 26:39
I would just add, Matt, that liquidity as well. In the fixed income market where a bond typically, the traditional sense of a bond, you would buy a bond and it would mature over time. You can buy a bond ETF or mutual fund today and sell that bond, mutual fund, or ETF tomorrow. They're very, very liquid. As the environment changes, it offers us a lot of flexibility. Antone, were there any others, or Robert, was there anything that you wanted to add?
Robert Steinberg 27:12
No, I think you guys covered it. The challenge with bonds is there are so many more bonds than stocks. A company could have 30, 40, 50 different bond issues. Each bond does not trade every day, where the company’s individual stock would trade every day. The difference between the price you pay to buy a bond versus sell it is usually wider for bonds than for individual stocks. It is often more efficient to sell a small amount of bonds in a bond ETF versus trying to go out to market and sell a small bond holding.
Matthew Mondoux 27:57
Dan, maybe really quickly you could describe how you find holdings in mutual funds? If you want to kind of get under the hood, you have mutual funds in your portfolio, you want to see what's in there. Maybe you can explain how that's fairly easy to do.
Dan Seder 28:19
It just takes a little bit of digging on the internet, but you can take the ticker symbol of what you own and go to any search engine, such as Google, and just type in that ticker symbol and "fact sheet." A fact sheet will generally give you a link either to the mutual fund company's site and a direct sourcing to that fund, or a PDF of a bunch of facts on that mutual fund. If you're on the company's site, there's generally a tab in the mutual fund, that particular holding, that shows everything that that fund owns as of the last quarter, so it's not always up to date. It doesn't necessarily mean that that's what they owned as of yesterday, but it's generally as of the most recent quarter, aAnd it's transparent. Those are all things that you can't necessarily see - the transactions on a daily basis or where they stand on a daily basis. It's certainly available information on the company's website. I think we could chat back and forth and ask each other more questions, but just in the interest of time, we've always tried to keep this to 30 minutes. I don't see any more questions in the chat box. Matt, Robert, should we call it a wrap?
Robert Steinberg 29:43
Sure. I really appreciate everybody joining us, and as Matt highlighted, we do certain webinars that are more educational in content such as this one, and then we do others that are much more time-sensitive market information. This one was on the educational side of things… Thank you for participating.
Dan Seder 30:13
Thanks, everyone. Have a great day.