“The average managed equity fund cost its taxable investors another 2.2 percentage points in taxes.” –John C. Bogle, Founder and Former Chairman, Vanguard Group
These days, Wall Street is looking like the financial equivalent of a war zone, with carnage as far as the eye can see. Through October 27, U.S. stocks are down 41.65% year-to-date, according to Morningstar. Large-cap stocks are down 40.38%; mid-cap stocks down 46.11%; and small-cap stocks down 42.53%, Morningstar reports.
The recent market upheaval has triggered the largest wave of monthly net redemptions in the history of the mutual fund industry states Morningstar. No asset class seemed to be immune. They reported the outflows flows for September 2008 ($47.5 billion) and the number exceeded the prior record month, July 2002 ( $17.4 billion), almost by 300%. Wow.
Mutual fund shareholders beware. This could be a smack in the head year in capital gain distributions. When the funds liquidate shares of stock to come up with cash for redemptions they sell stock that they may have bought many years ago at lower prices. This creates a gain that may be passed to current mutual fund shareholders. Imagine owning a mutual fund that is down for the year or just worth less than your purchase price and getting hit with a capital gain distribution. Paying taxes on a phantom capital gain could be the worst insult an investor may yet face for 2008.
A September 2008 Eaton Vance Investor Survey says as much. The survey found that investors are united in concern about the impact of taxes on their mutual fund returns, with more than four in five (81%) saying it is an important concern and nearly half (46%) saying it is a very important concern.
In point of fact, mutual funds are terribly tax inefficient. According a study by Money magazine, the average equity fund is only 80% tax efficient.
“Studies have shown that American equity investors may lose two percent in investment returns each year to taxes,” said Duncan W. Richardson, chief equity investment officer at Eaton Vance. “Given the volatility of today’s markets and the potential for lower prospective returns, a tax-managed investment strategy that might recapture two percent per year in overall returns is compelling.”
Tax Benefits of the Separately Managed Account
Unlike mutual fund investors, owners of separately managed accounts* have a built-in tax advantage. In fact, from stem to stern, managed accounts are more tax-friendly than mutual funds. Unlike investors in mutual funds who own shares of a portfolio, managed account investors are the direct owners of their stocks. As a result, managed account investors can tell their money managers to hang on to certain stocks to avoid capital gains taxes, or sell others to create a tax loss. That’s not so with mutual funds, where a fund investor’s capital gains situation is totally controlled by their fund manager. Try calling Fidelity Investments and telling the manager of the Magellan Fund to hang onto those eBay shares just a little while longer to avoid any capital gains taxes this year.
Consider a managed money account that buys 20 securities. Perhaps five to seven of those stocks drop in value by years-end. As a managed account, though, you have tax leverage – you can sell those stocks and take the loss.Conversely, a managed account investor can take his or her gains in a year in which he or she suffered other losses. That’s not a problem with a separately managed account.
Flexibility and leverage are great attributes to have in your corner as an investor, especially when it comes to taxes. It’s a painful lesson that mutual fund investors could well learn come tax season – but it’s a lesson that won’t have nearly as much impact on separately managed account investors.
Separately Managed Accounts or Mutual Funds?
Tax Related Features
Mutual Funds | Separately Managed Accounts | |
|---|---|---|
| Tax Considerations | Investment decisions are made without regard to your tax situation. For example, a fund may be forced to sell securities to cover redemptions, creating a potentially taxable event and/or negatively impacting returns. | Securities may be bought and sold with regard to your specific tax situation or financial needs—allowing gains or losses to be “harvested” to address your tax concerns. |
| Unrealized Capital Gains | The average US mutual fund has a 20% imbedded, unrealized capital gain. | The cost basis of each security in the portfolio is established at the time of purchase. |
| Customized to Control Taxes | Most mutual funds are managed for pre-tax returns, and investors pay proportionate share of taxes on capital gains. | With managed accounts, investors can instruct money managers to take gains or losses as available, to manage their tax liability. |
| Gain/Loss Distribution Policies | Virtually all gains must be distributed, losses cannot be distributed. | Realized gains and losses are reported in the year recorded. |
*A separately managed account is also known as a wrap account, managed account, separate account, individually managed account, actively managed account, privately managed account or discretionary account.
WrapManager, Inc. is not a tax advisory firm. We recommend you contact your tax attorney or CPA prior to utilizing any of the tax-related strategies mentioned or discussed.
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