In addition to the drag on annual returns from fees and expenses, mutual fund returns must also be reduced by the income taxes generated during the fund's tax year. Under the federal tax code, mutual funds are "pass through" entities which do not pay income taxes. They annually distribute all dividends received and capital gains generated in the portfolio to their shareholders, who elect to receive that money either in the form of a check or by reinvestment in the fund (more shares). Most distributions are made in December of each year.
If an investor buys shares in the mutual fund just before a distribution, that individual incurs a tax liability on the entire year's worth of income even though he or she may have only held the shares for a month or so. By way of example, assume you invested $500 in a fund and received 10 shares at a per share price of $50. Two days later, the fund makes its annual distribution, $5 per share. Assuming you elected to reinvest distributions, you now have 11.11 shares at approximately $45 per share. You still have the same $500 invested in the fund, but you owe taxes on the $5 per share distribution. Before investing in a mutual fund, an investor should check to see when the fund makes its annual distribution and time purchases accordingly.
To make matters worse, there have been loss years in which the mutual fund shareholders watched the value of their investment decline, but still had to pay capital gains tax. When the dot.com bubble burst, many mutual funds which had invested in high tech stocks ended the year with a loss. Despite the losses, the funds had sold quite a bit of the stock they had earlier purchased at much lower prices to meet redemptions, thus generating capital gains. The shareholders had to not only watch their investments lose money, but also send a check to the IRS for gains that were of no economic benefit to them.
None of these tax
issues matter if you hold your mutual fund investment in a tax deferred retirement account, such as an IRA or a 401 (k).
Much has been written about the apparent inability of a majority of actively managed funds to beat general market averages. As stated in the last post, due to the imbalance between the number of funds investing in the stock market and the smaller number of stocks available for such investment, it could be that the mutual fund industry actually comprises the market. Subtracting the fees and expenses of the funds must therefore result in a return lower than that of the market. In his 2003 book, Investment Philosophies, Professor Aswath Damodaran cites three behavioral factors which might be seen to also contribute to this shortfall in return: lack of investment consistency, herd behavior and the practice of window dressing.
A mutual fund's prospectus states its goals and the investment philosophy it will use to reach them. Unfortunately, studies have revealed that investment advisers will pay only lip service to these stated objectives in times of market turmoil. Fund managers have been seen to repeatedly switch their investment styles in response to the latest market moves, up or down. The second factor, herding, is simply a human trait. Human beings tend to act collectively, much like other species. With so many market professionals engaged in the same activity, it should be no surprise that institutional investors tend to buy and sell the same stocks at the roughly same time. This magnified action will tend to drive stocks up or down to a greater degree than might otherwise be expected. The third behavioral factor, window dressing, also reflects human nature. It is well documented that fund portfolios are subject to a noticeable amount of change just prior to the dates on which the funds must report their results and reveal their share holdings. The losers are sold, and the most recent market winners are purchased just prior to reporting results. The basis for this might be, in part, the cynical belief that the investing public will pay more attention to the reported portfolio holdings than the actual returns made during the period. Such activity is self defeating since it results in increased trading costs and a concomitant decline in returns.
Looking only at portfolio holdings or returns is not the recommended way to invest in mutual funds. We will look at how to invest in funds in the next post.
Comments are always welcome.