Mutual Funds 102: Basics That Investors Need To Know

In this second edition of our series on mutual funds, we explore some further impediments in the use of mutual funds. Limited transparency, lack of control over capital gains distributions, and unintended concentrations can create financial planning issues for an investor. Part One of our series on mutual funds focused on the costs (both direct and indirect) that are passed along to investors. Loads, transaction fees, and ongoing expenses can be costly.

Transparency

The nature of mutual funds and the quarterly disclosure requirements for fund holdings mean that you are unlikely to know exactly how your money is invested at any given time. This fact could impact your investing behavior even if you do not realize it.

The endowment effect, for example, can have a powerful influence on your investing choices. This inherent behavioral bias leads shareholders to retain an affinity for the companies in their portfolios, making it easier to weather the ups and downs in share prices.

Knowing how many shares you own in what specific companies, such as McDonald’s or Home Depot, can help you foster a longer-term investing mindset. Seeing long lines in the McDonald’s Drive Thru every morning can help you weather a decline in the price of McDonald’s stock more easily— as you’re more apt to say, “Look at all those cars! McDonald’s isn’t going anywhere.”

When you invest in a mutual fund, you may have no idea what stocks you own, a circumstance that negates this endowment effect. Actively managed mutual funds generally trade securities within the fund with some frequency. As an investor in that fund, you do not receive a confirmation of these intra-fund trades. At best, you can find a list of the fund’s top holdings in its quarterly 13-F filing that is required by the SEC. As a result, it’s difficult to fully understand the fund’s underlying holdings.

Mutual funds create a separation between the investor and the companies they own though the fund. As a result, it becomes very easy to divest yourself of that mutual fund as soon as its investment performance suffers, whether doing so is warranted or a good idea.

Statistically speaking, even mutual funds with the best long-term track records experience periods as bottom-tier performers amongst their peers. Poor performance coupled with a lack of transparency often results in mutual fund shareholders selling at exactly the wrong time. Think of it like jumping lines in the grocery store….we all know how well that typically works (“Price check on lane 3!”).

Inefficient Tax Management

Tax loss harvesting is an important tool in financial management that involves selling an investment at a loss. These “harvested” losses can then help you offset capital gains taxes when you sell holdings that have increased in value. Harvesting losses is easy to do when you own individual stocks. However, tax loss harvesting using mutual funds is only possible when the entire fund is selling at a loss.

In addition, mutual fund shareholders receive capital gain distributions at least once a year, if not more frequently, based on the gains the fund has realized by selling some of its holdings. The only way to avoid these distributions is to liquidate your holdings in the fund before the distribution date. Yet, even if you manage to avoid the distribution, you still may face capital gains taxes if the shares you sell have gone up in value. When this happens, you have to choose between the lesser of two evils—taxes on distributions or taxes on the sale of shares. We’ll leave the discussion about whether taxes are an evil for another day.

Year-end capital gains distributions can be particularly unwelcome if you bought shares in the fund late in the year. Let’s say you purchased XYZ mutual fund in October while the fund was on a roll so you could jump on the gravy train. The fund’s shares begin to decline shortly thereafter, and your shares end up down 10% by the end of the year. Adding insult to injury, the fund manager sold some winners, thereby creating a large taxable capital gain distribution even though you have not made a dime in the fund itself!

Mutual fund capital gains distributions can derail tax planning and undo solid financial planning. For example, suppose you have managed your annual tax withholding to cover your expected annual tax liability. Capital gains distributions could upend this careful planning and create a cash flow crunch as you look for the liquidity to satisfy this additional tax amount. This situation could also make it necessary for you to make quarterly estimated tax payments to cover future distributions the following tax year.

Unintended Concentration/Lack Of Coordination

Mutual funds come in all shapes, sizes, names, descriptions, and investing styles. This may lead you to assume that you have broadly diversified holdings if you buy shares in a variety mutual funds. However, if you summarize the individual securities held by those mutual funds, you might be surprised to find that you have an unintended concentration in a handful of companies.

Thanks to the “staple” holdings that a great majority of mutual funds own, you may not be as diversified as you might expect. Although a mutual fund cannot own more than 10% of any company’s shares, owning shares in a series of mutual funds whose top holdings overlap will not help you meet your diversification goals.

A significant price decline in the most widely held stocks can negatively impact multiple mutual funds in what otherwise seems to be a diversified portfolio. In fact, you may find that your investments look a lot like an overall benchmark or index even though you are paying a fund and its managers far higher fees for active management.

A portfolio of mutual funds also comes with an inherent lack of coordination among the managers. Fund managers are solely in the business of outperforming their benchmark, not understanding the unique needs of each investor. Mutual fund managers are not debriefed on the other holdings in your portfolio. They will not call each other to ask about your unique situation prior to adjusting their holdings. Consider this scenario, one fund manager could be selling shares of XYZ stock while a different fund held in your portfolio is buying the same stock. These offsetting transactions are highly inefficient and can negate the benefits associated with active management.

Unique Investors Deserve Unique Holdings

Every investor’s needs are unique, which should be reflected in their investments. Fully understanding the construction, characteristics and costs of mutual funds can help you assess whether these financial products should play a role in your asset management and financial planning.

Lifting the veil on mutual funds, one of the most popular investment vehicles used today, can be enlightening. The key is to use the knowledge you gain to make better and more informed financial and investing decisions. Don’t settle for the path of least resistance when investing. While you can make money by investing in mutual funds, there may be a better way forward.

If you have any questions about mutual funds, please contact a Blue Chip Partners financial advisor for guidance. We are here to help.

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