For Starters, an Investor Might Look at a Fund’s Holdings, Management and Philosophy.

If you’ve read Mutual Fund Matters a few times, you know I’m a big fan of mutual funds as the recipe for a “nutritious” main dish. Mutual funds are the ingredients for a balanced menu for your core portfolio. That doesn’t mean they’re perfect, however. Let’s take a look at some of the very real drawbacks of investing in mutual funds.

A Preselected Portfolio

When you invest in a mutual fund, you have to stick to the menu and serving size. If it’s an index fund, the manager will buy investments in the same proportion as what’s in the benchmark index. In the S&P 500 index, the 10 largest companies account for nearly 22% of all holdings, so if you’re already holding, say, Apple as an individual stock, you may own much more of it than you think if you also have it in a mutual fund. Similarly, while you may like the holdings in a given fund, an individual company may constitute a very small percentage of total holdings.

I also advise scrutiny of exactly what index is being used, because there are enough different combinations out there that while some indexes are what­ever they say they are — they also can be increasingly sliced and diced to meet a manager’s idea of what investments should be made.

For actively managed funds, you should scrutinize not only the holdings of a fund, but also the underlying philosophy. Because of reporting requirements, it can be hard to determine what exactly is in a fund at a given moment; if the fund has a corresponding exchange-traded fund, the ETF is required to report daily holdings. But if you would object to specific holdings, you might want to review at least the largest investments, i.e., the 25 largest holdings.

My clients have been surprised to find gun manufacturers, banks whose practices they find offensive and large polluters in some funds. In contrast, clients have objected to the stated objectives of even so-called sustainable or socially responsible funds. For example, one excluded any company involved with women’s health care, something many clients would like to include. You have to determine what criteria are used in determining investment selections, and whether you agree with the selection criteria or investing philosophy. Taking a look at the holdings will make certain you don’t have an allergy to any of the ingredients. While the purchase of any mutual fund does require you to extract information from sources such as Morningstar and the fund prospectus, it’s certainly not as difficult as assembling a balanced portfolio of individual stocks and bonds. The manager’s selection has done some of the work for you.

Manager Changes

When you’re investing in a broad spectrum fund based on a widely understood index (S&P 500, MSCI World Index, Bloomberg Barclays U.S. Aggregate Bond Index) it matters very little who the head chef is — contents are being selected by algorithm, and the management just needs to maintain low management costs in order to adhere closely to the index performance.

For balanced funds, socially responsible funds and any sort of special emphasis — dividend growth, dividend yield, total return, etc.— the manager or team very much runs the offerings. What stocks are emphasized, whether the balance between stocks and bonds is tweaked, and what the specific investment philosophy is can all change dramatically with a new manager. While it seems the press and public believe that some managers never have a failure, sooner or later most burn out by failing to beat “the market.” The departure of the star, alone, can cause so much outflow of funds that the fund is forced to liquidate investments to pay for withdrawals, and share prices can deflate as well.

Even target retirement funds composed of a mix of index funds have a certain manager dependency — regardless if the mix of funds is more dependent on a company than an individual manager’s recipes. Compare a few target date funds for the same retirement year and you’ll see a lot of disagreement as to how much international or how much bond investment a specific timeline should contain, and how quickly the fund gets more conservative. Be aware that management can decide to change the balance at any time and likely will if their fund lags the performance of other competitors.

Portfolio Turnover

Index mutual funds should change only when the index changes. Even a drop out of the 10 biggest (as Exxon Mobil did in 2019) can change the mix of the fund, and managers will respond immediately. Being dropped from an index signals a company with big problems: Sears, Avon, Radio Shack and Lehman Brothers all bit the dust. Dell Computer went private, but managers nevertheless needed to adjust. Some funds are “index-like” in that they attempt to meet or beat an index but have the freedom not to replicate it exactly. These managers have more control over whether and when they turn over their fund’s portfolio.

An active, aggressive manager may turn over the portfolio 100% or more in a year. Even with similar funds, the turnover can be very different. For example, the Fidelity Puritan Fund (ticker: FPURX) has a turnover of 132%; the Vanguard Wellington Fund (VWELX) has a turnover of 28%. There are several disadvantages to high turnover:
  • Higher management costs to monitor all the movement;
  • Increased possibility of wrong bets;
  • Higher capital gains from the transactions, and therefore possibly higher tax consequences for investors;
  • Difficulty of determining what’s in the portfolio at any given time.
Of course, there’s one possible advantage: The manager is a genius who can pursue ever better opportunities, can profit from short term bets and harvest tax losses. There’s no evidence that someone can do this long term.

Phantom Gains

This is mainly a concern for investors holding mutual funds in taxable accounts. Let’s say a manager changes and there’s a mass exodus of investors. The fund may be forced to sell investments in order to meet redemption obligations. Those investments may have increased in value, so the fund will incur capital gains, but at the same time the fund’s share prices may drop. So, you might be on the hook for capital gains and taxes, while still seeing the value of your investment go lower. Managers strive to avoid this, but it does happen.

Tax Efficiency

Do some careful calculations before you bite into a so-called tax efficient fund. These are most frequently seen in bond funds, where the manager will invest heavily in types of bonds that are not subject to federal income tax: zero coupon and municipals.

For “tax-efficient” stock funds, managers will emphasize low turnover, non dividend paying stocks and avoid interest paying investments. But you should be careful that you are in a high enough tax bracket to actually make this worthwhile. Right now, bonds are already mainly low-yielding investments. You have to have quite a bit of money invested, as well as a high tax bracket, to make accepting even lower yield worthwhile. Search for the “tax equivalent yield” calculator at bankrate.com to determine whether this is worthwhile for you.

Some types of funds — real estate investment trusts (REITs), commodities and master limited partnerships — can have complicated tax pictures because you’re actually a partner in the operations. Make your accountant happy by holding these investments (if at all) in tax-free or deferred accounts.

If you expect significant capital gains on specific investments (don’t we all!), you actually may be better off holding them in taxable accounts, depending on your tax bracket, in retirement. The top tax on capital gains is 20%, but retirement account withdrawals or distributions are taxed as ordinary income.

If your tax bracket at retirement is higher than 20%, you’d be better off paying capital gains and deducting losses, which you can’t do in retirement accounts. This is mostly a concern for people at or near retirement. Others will probably benefit from long-term tax-free growth, piling as much into tax-free growth as possible.

Finally, ETFs are marginally more tax efficient than many mutual funds. ETFs are generally passively managed, have low management fees, and can (theoretically) be timed to sell at a precise point to maximize gains or harvest losses. In addition, they don’t have to liquidate investments to pay withdrawals, as investors simply sell shares on the open market.

Check the management fee and portfolio turnover of any ETF you’re considering. If the company offers different share classes of a mutual fund, some may have similar or identical portfolios and fees to an ETF. None of these ingredients should scare you off from a main diet of mutual funds, but, as with every dish, you should be aware of what you’re eating.

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This article was originally published in the May 2020 issue of BetterInvesting Magazine.

These funds are mentioned for educational purposes only; no investment recommendations are intended. The author and some of her clients may have positions in some of the funds mentioned in this article.

Danielle L. Schultz, CFP, CDFA, is a fee only financial adviser with Haven Financial Solutions, Inc., based in Evanston, Illinois. She’s the author of “Idiot’s Guide: Beginning Investing.”

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