Scratching the surface on mutual funds

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Mutual funds make up such a broad segment of the financial services industry, its hard to know where to start.

I had all these ideas last night that I wanted to write about, but today as I sit here I realize I can’t possibly incorporate them all into one or two posts.

I think, instead, in a few weeks time I will dedicate an entire week to looking at the mutual funds industry. It’s really the only way I can do it justice.

When it comes to mutual funds, there are so many interesting things to write about, including uncovering some dirty little secrets. In fact, I’ll dedicate the same amount of time to the annuities business, as well.

I got a little excited, a little ahead of myself today. Consequently, I just changed the post title to the one you see. It went from ‘Understanding mutual funds’ to what you see up there now. Well, lets begin to scratch the surface on the mutual fund biz then…

(I’m going to assume you know the basics about mutual funds, if you don’t and want more information Click Here.)

Scratching the surface

For many years I advised clients to stay away from most mutual funds and buy ETF (exchange traded funds). I have softened my stance a little bit, for a couple of reasons:

• there are some excellent low expense, tax efficient, positive alpha funds out there
• the regulatory environment has changed
• equity mutual funds aren’t as gorged, with embedded capital gains, as they were in 2000-01, 2005

But for the most part when investing in mutual funds I say… proceed with caution!

Be careful

The majority of client asset allocations I construct, overwhelmingly, involve ETF’s, because I like their simplicity, efficiency and transparency (decided to break out the fancy words).

But that doesn’t mean there are not good mutual funds out there, because there are. I just think, with mutual funds, you really need to do your homework, examine the cost structure of the specific fund and stay on top of what’s happening at the fund in question.

You need to be able to justify why you’re investing in a specific fund. I would be willing to bet most GenXer’s could not give me 2 good reason why they own the funds that they do in their 401K’s, IRA’s or regular investment accounts?

If you’re going to own a mutual fund, the best place to own it is in a retirement account. Mutual funds benefit from the tax deferred status associated with retirement accounts, so you’re exempt from paying taxes on the funds capital gains distributions, a very good thing.

Every last drop

Part of being an advisor, is putting together the most efficient portfolios you can for your clients, squeezing out every last ounce of performance, with as little slippage as possible. Mutual funds held in regular accounts generally have capital gains distributions that are passed on to you… which means you owe taxes… which signifies slippage.

Different funds have different size distributions, depending on the objective (and aggression) of the fund, fund turnover, amount of built in unrealized returns, trading commissions, etc.

Oops… scratch that last one (trading commissions), that’s not part of the capital gains distribution, rather it belongs in a category all to itself; we’ll cover the mystery behind mutual fund ‘trading commissions’ during ‘Mutual Funds’ week.

Unprecedented run

I was very wary of most equity funds back around Y2K. You have to remember, most mutual funds had unprecedented runups and had huge profits that had to be passed off to fund investors at one point or another. Back then, owning certain funds was like owning a ticking time bomb.

I remember having a calendar with the dates of capital gain distribution on it; I remember fund wholesalers offering sales ideas on how to exchange into funds, within the same fund family, in order to avoid the large distributions.

Well, I think we scratched the surface. I’m going to spend next week examining some pretty cool financial calculators that are very effective. I got a little ahead of myself here today, starting to focus a bit on the micro issues instead of the larger macro issues this blog was designed for.

Back fresh in the morning…

Tags: ETF, Mutual Funds