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Make sure to evaluate investment options

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By Gary Boatman
Wednesday, Feb. 13, 2013, 12:01 a.m.
 

Last week, we started our discussion about mutual funds.

They are the most popular way for individual investors to invest in the market. This week we will continue that discussion. We talked about some of the fund expenses last week. The 1.31 percent average is reported in the prospectus at Morningstar.

It as been estimated by the Plexus Group that the annual unreported trading cost could be 4 to 6 percent. This is because these funds keep buying and selling shares as their objectives evolve. If you own the funds in a non-qualified account, you could have a tax consequence for these trades since they generate capital gains and losses. Tax is due on qualified accounts only when the money is withdrawn from them.

Mutual funds are managed for the masses and not the individuals. You do not own the shares of stock, the fund does. That means that they receive the dividends – not you. Also, they do not consult with you about your tax plans. If you own individual shares of stock or own the shares in a separately managed account, you can select which shares are most tax efficient if you are only selling part of your position.

You can decide to offset specific gains or losses in individual shares or SMA. This cannot be done in mutual funds. It is important to remember that long-term capital gains are taxed at only 15 percent. Short term are taxed at your marginal rate of up to 39 percent. If you have income more than $250,000, you may also be subject to the new “Obamacare” surcharge of 3.8 percent.

Mutual funds are also not permitted to pass along their net capital losses in the year that they are incurred. This means that you must remain in the fund to get this advantage unless they have gains to offset them. When making donations or for estate planning, you do not have the same flexibility with mutual funds as other instruments to use low basis investments.

People always want to buy the mutual funds with the most stars in their ratings. Often the fund with the best performance this year, is way down the list next year. This is because so much new money flows into the fund, that the manager must buy companies that he or she would not have ordinarily bought. He cannot just keep the new money in cash since that would produce a zero percent gain.

Mutual funds by nature own hundreds of different company's stock and bonds. An academic white paper by Harvard University and the London School of Economics argues that investors would best be served with more concentrated portfolios. They fund average improvement of one to four percent per quarter in earnings over more diversified investments. Mutual funds with more concentrated portfolios cannot typically achieve four- and five-star ratings from Morningstar. They like to see wide diversity for safety. Ninety percent of all inflows go to highly rated funds. Managers know this and they get paid to attract more funds not for their investment performance.

Mutual funds have also lost many of their top managers. The hedge fund industry has grown rapidly and can pay more and has less regulations. Private equity funds are another area that is siphoning off talent. Mutual funds are also facing competition from lower cost ETFs.

Mutual funds may not be your best choice for investment options. As with all financial decisions, you need to carefully evaluate all of the alternatives.

Gary Boatman is a certified financial planner and local businessman who serves as president of the Monessen Chamber of Commerce.

 

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