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active management

The Tax Man Cometh and Your Investment Returns Goeth...away?

Clearly, 2013 was a great year in the market. But just like Halloween, your 2014 return is coming around to haunt you. 

Last weeks dip in the market prompted many mutual funds to sell of considerable gains that they had carried forward from 2013. Both stock and bond mutual fund managers were sitting pretty, with built up gains that they had yet to get out of, poised but waiting for the right moment. And, sure enough for many, last weeks dip in the market was the exit point. 

Mutual funds must distribute their realized gains to shareholders. When that happens, the shareholders must then pick up those capital gains on their tax returns. The cost of paying those taxes should be considered a direct reduction in your return because they are in fact a direct expense of owning your mutual fund investment. 

A recent Reuters article goes on to say that stock mutual fund investors could be hit worst of all. Morningstar Analyst Russel Kinnel estimates that stock funds could be sitting on gains of around 20% and could end up paying the majority of that out as gains to shareholders. 

Coupled with ongoing expense ratios for mutual funds in the range of about 1.4% per year and adding in undisclosed trading costs of what amounts to another 1% or so, the typical investor who owns an actively managed mutual fund is paying somewhere around 2.4% of their portfolio value every year in expenses, and that's before you factor in taxes and commissions. No wonder American's are having such a hard time building a nest egg for retirement or any other goal. 

This coming April might be especially daunting for investors.  Many people had carry-over losses from the last market downturn and had been able to offset gains for a few years with those losses, but for many, the pool of available offsets has run out. 

The Rise of ETF's and Indexing

More and more investors are realizing that investing is a zero-sum game. There's only so much money to go around.  One mutual fund managers 10% gain has to be by definition another mutual fund managers 10% loss. While fund managers struggle to out perform a passive benchmark (the S&P 500 would be one example of a passive benchmark) they all seem to have forgotten that their desire to "beat the market" is inexorably complicated by the fact that by and large, they are the market. 

Indexing and the use of Exchange Traded Funds (ETF's) can minimize many of the costs that an investor faces. Not only is there no "management" team who have to have salaries paid, space rented, research conducted and distribution costs paid, but indexing by definition will largely eliminate the costs of any active trading in the portfolio as well. That could amount to a reduction in expenses to the end Client of as much as 2/3 over an "active" strategy. 

And there's a potentially more important payoff; the possibility of higher and more consistent performance. 

No one can guarantee or assure performance improvements, we all know that. But a recent study by Dimensional Fund Advisors shows the following factors as it relates to "active" vs. "passive" investing; 

  • LARGE CAP CORE- active fails to outperform passive roughly 95% of the time
  • MID CAP CORE- active fails to outperform passive roughly 94% of the time

(Note: the best performing active option is in Small Company Value with a 54% in Small Company Value as noted below.)

And even where active stands a fighting chance in asset classes such as Small Company Equity, active still fails to beat a passive bet 68% of the time in Small Company Core, 77% of the time in Small Company Growth and 54% of the time in Small Company Value. 

The track record on bond funds in the "active" vs. "passive" debate is even worse, where Municipal Bond Funds  (failing 98% of the time), Intermediate Municipal Bond Funds (failing 100% of the time), Short Term Municipal Funds (failing 96% of the time), High Yield Bond Funds (failing 97% of the time) and TIPS (failing 100% of the time) make an active management decision a benefit to the sales person and the fund company but clearly not the investor. 

For the record, no one can tell you what active funds will [a] beat a passive strategy, [b] that beating a passive strategy in one period provides any assurance that the same manager will beat it in the next or [c] that beating a passive option one out of five out of ten years will accumulate more money than the passive option since that would be dependent on what the actual returns were period by period. 

If you've chosen an active management bent to your investment program, the research is pretty clear, it'll be expensive in terms of costs, expensive in terms of returns and expensive from a tax standpoint. 

But how much difference does it really make?

On a $500,000 portfolio over a twenty year period a 2% difference in returns is the difference between $1,603,567 and $2,330,478 or roughly $700,000. 

Want to make progress toward retirement, college funding, buying a vacation home or just simply living out your life in reasonable comfort?  I'll bet $700,000 in additional wealth will help with no additional out of pocket cost!

Last year, PBS Frontline reviewed for everyone the negative impact of active management costs AND THAT WAS IN RETIREMENT ACCOUNTS.  That's important because of course, the implications for taxes aren't considered in retirement accounts. Taxes would be an additional costs on top of the expenses and any commissions paid.  I'd urge you to watch this series which is still available on the Frontline website. (Note: If you click on the graphic above it'll take you there.)

At Barry Capital we realized a long time ago that active management was, in our opinion, a fools game.  It's a story, artfully told about how, with time, talent and tenacity (and a whole lot of your money) a dedicate individual or group of individuals is going to show you how to beat the market. 

One small problem.....there's no chance that it will happen with enough frequency to make anyone any more money. Unless you're the fund company that is. 

Throwing A Hail-Mary With Your Money

If Wall Street cared about your future before it's own....well, that's not going to happen now is it?

If Wall Street cared about your future before it's own....well, that's not going to happen now is it?

"Fund managers like these guys who are underperforming are going to want to make themselves look good for the rest of the year and make up for lost ground. There's going to be an effort to pull out the year in the last month."

"Fund managers like these guys who are underperforming are going to want to make themselves look good for the rest of the year and make up for lost ground. There's going to be an effort to pull out the year in the last month."

So says a recent article

It seems to me that you should be the key person in your investment relationship. 

It would seem fair and appropriate I think, that your goals, and your interests should be the ones first served. 

The statement from seems to portend that active investment managers now know what had escaped them for the first eleven months of the year, namely how to make money in this market. 

That would of course, beg the question, "what changed?" Since the only real change is the focus of your investment manager, you might ask, how many boundaries will get crossed, how much additional and unwarranted risk will get taken, and how many "policies" will get overlooked in the interest of "pulling out the year?" Are those actions that are being taken something that you signed on for? Are they policies that you approved? Are they risks that you agree with? Doesn't seem to matter does it? No, because this isn't about you, its about them. 

If you're investing (not gambling) then contrary to their belief it's ALL about you. It should be about your willingness to take that risk, your willingness to minimize unnecessary transaction costs and taxes. But in the world of active management, it's much more likely to be about what they want, not what you want. 

We control very little in our lives anymore. We don't get to set economic policy and we don't get to decide on the direction or velocity of the stock market. That being the case, we should control what we can control, namely how our investment professionals respond to the fact that we exist at all. This fact, that it's your money, is something that should never be overlooked or trivialized. 

When the focus becomes "pulling out the year" understand that the effort, while likely doomed to fail before it even starts based on any reasoned objective measure, is being played out with your retirement/college fund/kids wedding money.

So if December becomes the month that a strategy worked, you might want to ask yourself how that happened and what changed? Why wasn't that the strategy employed throughout the year?

If it fails, you might want to consider who'll be harmed when it doesn't work?