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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. 

The Retirement Gamble from PBS

You know, the advisory business is a strange business.  

Regulators say that we can't use Client testimonials in our advertising or marketing materials.  The bottom line is that you can get a succesful Botox injection or buy an awesome lawn mower and your customers can espouse your virtue everywhere and at almost any time. 

But as Investment Advisors we can't display our happy customers.  

So, you have to find another way to tell the story.  

In "The Retirement Gamble" that appears on FRONTLINE on PBS, you can hear about the retirement conundrum that's facing millions of Americans.  

It's Wall Street v. Main Street but this particular battles been going on for years.  

Watch, "The Retirement Gamble" here...


Do We Know We Don't Know?

It's a really good question and one which, evidentally, most people get wrong most of the time. 

Mostly, no, we don't. We think that we can define our future, yet fail to actually do it. Knowing how to do it isn't really doing it. 

Mostly, no, we don't. We think that we can define our future, yet fail to actually do it. Knowing how to do it isn't really doing it. 

The good news (sort of) is that the people that get it wrong are a lot more of the people than you think. 

We've been pursuing passive investment strategies now for more than a few years, knowing that we do in fact know. 

I love it when an article concludes with the comment: "Finally, it's my experience that the vast majority of investors don't even know what their returns have been relative to appropriate benchmarks. One reason is that Wall Street doesn't want you to know- if you did, you might stop making it rich. Another might be that the truth would be too painful, so investors themselves don't want to know. But you should know. Without such information, there is no way to know if your strategy is working."

In this great article, "On Magical Thinking and Investing" Larry Swedroe hits all the high notes. 

Read "On Magical Thinking And Investing" here. 

Are Fund Managers Ever Worth The Cost?

The answer is, no, they're not. And there's tons of research to back it up. 

The answer is, no, they're not. And there's tons of research to back it up. 

One of our core beliefs is that investors should always pay attention to the expenses of their investments. Every dollar needlessly spent chasing returns is a dollar that should be in your pocket not someone else's.

Reducing the money that you have at work by paying costs that don't directly result in bottom line benefits to you will hurt your chances of meeting your long-term goals.

A strategic decision for every investor is the passive v. active decision and this is where one decision can save a lot of money over time. And, because we're talking about expenses, the savings are a sure thing.

In theory, investors pay for active management because a manager will use their skill in security selection to outperform and index such as the S&P 500. Well, the cost of trading, research and such all raise your bottom line costs, perhaps to an unconscionable level.  

Does this additional cost result in additional returns? No, according to in this recent article "Market Pros Had a Bad Year, So Why Not Buy and Index Fund?"

Are you paying too much for your current investment program? Want to find out for certain if you are or not? Use our Connet With Us form to let us know, we'll contact you to arrange a mutually convenient time to meet. Our evaluation is done on a no-cost, no-obligation basis.