Prior to the 1990s, most investors avoided mutual funds. But, with the stock crash of 1987 and a more volatile investing climate, investors sought refuge in mutual funds. Mutual funds are now found in almost 90% of all portfolios and they remain a popular and effective investment tool.
A mutual fund is really a company. The point of the company is to convince investors to trust the company with their money and allow it to invest on their behalf.
The company then purchases stocks, bonds, and other investments with the capital it raises. Every investor then owns a percentage of the company in the form of stock – just as with any other publicly-traded company. Each share of stock in a mutual fund represents a percentage of every single investment and shareholders can opt-out at any time, though there are usually fees assessed.
The principal advantage of a mutual fund investing strategy is reduced risk. By spreading the capital out over a number of investments, the risk of loss decreases. The more diversified the mutual fund, the lower the chances for a loss. Of course, a more diversified portfolio also reduces the chances of big gains as no single winner will affect the overall earnings significantly. However, several mutual funds posted huge profits during the 1990s and beyond which is why they remain so popular with investors.
However, one of the dirty little secrets about mutual funds is really no secret at all: you have to pay capital gains taxes when you cash out. The reason why the average investor fails to consider taxes when purchasing or selling mutual funds is because most brokers could care less. Brokers are trying to make money like everyone else and they are more concerned about commissions – the taxes on capital gains are the investor’s problem.
But the investor needs to consider tax liability issues when buying a mutual fund because tax effects are certain and very predictable – the next big winner is not. This is why the investor should always consider the tax efficiency ratio of a mutual fund. The tax efficiency ratio will tell the investor what percentage of the pretax return the investor was able to hold onto once taxes were paid. The tax efficiency ratio is not provided by the mutual funds but can be found in a number of investment services that have begun computing this ratio. The higher the ratio, the more money the investor keeps of the original pretax earnings once taxes are assessed.
It is tempting for an investor to consider a “no-load” mutual fund because no sales commissions are charged, though the standard management fees will necessarily be assessed. However, it is quite common for most no-load mutual funds to distribute capital gains annually – in fact, the law requires that mutual funds make capital gains contributions to shareholders any time a security is sold for a profit from the fund. These capital gains distributions may not be good for investors with larger portfolios as they may need to offset gains with losses in order to minimize tax liability (the only exception to the capital gains distribution rule). It is therefore a good idea for an investor with a larger portfolio to use a money manager or the trust department of their bank to manage investments. Such investment professionals are paid a commission based upon your earnings after taxes, making them much more likely to pick the best times to declare income and capital gains from investment activities.
But for the individual investor without a massive portfolio and the luxury of paying money managers, there are some ways to minimize capital gains while maximizing profits. Where mutual funds are concerned, it is important to understand the realized capital gains of the portfolio.
Depending on the mutual fund, it is common for there to be a capital gains distribution every year or in regular intervals. This is essentially like a cash payout for a stock dividend. Basically, the mutual fund is sharing a portion of the profits with investors. And just like a dividend, the capital gains distribution is income and must be taxed.
An investor is encouraged to ask about the realized capital gains because if they are in excess of 5 percent and the capital gains distribution is near, it may be better to hold off buying until after the distribution. To understand why consider the following example:
Assume that an investor was considering purchasing 1,000 shares of a mutual fund for $20 each and the date is December 28th. January 1st is the record date and when the mutual fund will have a capital gains distribution of $2/share, or 10% realized capital gains. Now the investor will have invested a total of $20,000 and own 1,000
shares if he/she were to buy the mutual fund on December 28th – and the investment will be worth $20,000. However, for this investor, the distribution of the investment will change in the New Year: the share price of the mutual fund will drop to $18 after the capital gains distribution (barring any changes due to market influence). Thus, the 1,000 shares are now worth $18,000 and the capital realization is $2,000 – the investor must now pay taxes on this $2,000. By the time taxes are paid and fees assessed, it will probably end up costing this investor more if the mutual fund is bought on December 28th as compared to making the purchase on January 2nd when the tax liability could have been avoided.
Of course, the capital gains distribution will not be of great importance if you are only making minimal investments at regular intervals. However, for an investor looking to make a lump sum investment, the record date and realized capital gains percentage will play an important part in when and how much is paid in taxes.
It is also possible for an investor to lower their realized capital gains from selling a profitable mutual fund by also selling a losing fund at the same time. Unless there is some genuine hope for recovery of a losing fund, it is better to use it to help lower tax liability than to hold onto it for a turnaround that may never come. Remember, the tax liability is certain while a sudden change in fortune for a losing fund is but a dream!