At one time, mutual funds were useful investments. It used to be difficult and expensive for individuals to own many stocks and create their own portfolio to help get the benefit of diversification. So, mutual funds probably provided, at one time, what might have been one of the best available investment alternatives.
However, to obtain the benefit of diversification through mutual funds, investors can suffer Many costs. With the technology that is available today, mutual funds can be considered an outdated, and therefore a potentially flawed, way to invest. So, why are mutual funds flawed? There are many reasons. Here, I will discuss a few.
Reason #1 – There are no tax advantages to mutual funds, only disadvantages. If you pay taxes and you own mutual funds you have created a natural adversarial relationship. The tax flaw of mutual funds is called Embedded Capital Gains or Phantom Income. This is something that most investors never hear about. On the surface capital gains sound like a good deal – but in reality capital gain distributions from mutual funds can pose a tax nightmare for investors – especially for those who invest in mutual funds in taxable accounts.
You as an investor in a mutual fund do not actually have to do anything to receive this tax bill – you don’t have to sell the mutual fund or be taking income to trigger the taxes. You actually don’t have a say in the matter.
So what are embedded capital gains – Mutual funds can have anywhere from 100 stock in their portfolio to 1000. Because the fund manager is trying to get as high of a return as possible he is buying and selling stocks continuously. Many of the stocks that are sold are sold for more than what they the fund paid for them. When there is a gain on these transactions, mutual funds are required to distribute capital gains to investors of the mutual fund. These capital gain distributions are reported on a 1099 form and are taxable.
And here’s a kicker, having to pay capital gains tax doesn’t just happen in up years. In 2008. Investors in taxable mutual funds were hammered twice – the average mutual fund value was down 40%. How many investors bailed out of the market in 2008 – a lot. Because of the mass exodus from mutual funds it created a wave of redemption’s. When a fund manager sells stocks that have lost value to cover redemption’s it creates embedded capital gains for all of the investors. Let that sink in for a bit – you lost money and you still have to pay taxes on that loss.
Because of the way that mutual funds are built it does not matter when you buy into the fund. If a mutual fund manager sells a stock within the mutual fund in January and creates a capital gains tax. And you invest in the fund in December, you will still have to pay the capital gains tax for the stock sale in January.
Stay tuned for the rest of the story of why you probably have outgrown mutual funds. This story doesn’t get any better.