The Reasons Your Mutual Fund Doesn't Give You the Return You Expect

(ARA)— Many investors in mutual funds are beginning to grimace as tax season draws closer. The tax bill for most mutual funds is still hefty even though their returns were lower last year.
Last year, the average US stock mutual fund finally outperformed the S&P 500 after years of underperforming the benchmark. According to James O'Shaughnessy, CEO of Netfolio.com and author of the best-selling book What Works on Wall Street, investors in the average fund actually lost around 3% when you factor in the fees and capital gains taxes they have to pay, even though the average fund was down only 0.37% compared to the 9.1% decline in the S&P 500.

"Mutual fund performance figures often leave out the taxes and some fees you are required to pay as an investor," says O'Shaughnessy, a former mutual fund manager and the creator of a new investment service that removes the major negative aspects of mutual funds. "The little guy is left thinking he didn't do too badly when in fact he didn't do nearly as well as he thought."
The Securities and Exchange Commission is also feeling frustrated. The SEC recently announced new regulations that require mutual funds to reveal information that they haven't for years: how income taxes affect the performance of the fund.
Investors in the 1990s largely ignored their tax liability and the unstated expenses associated with investing in mutual funds. Taxes were a non-issue due to the bull market funds' strong and consistent gains. However, many investors are now realising the unfairness of paying high taxes on funds that have lost value as they prepare to pay taxes in April.
What impact do taxes have on fund returns? Assume that in January 2000, you put $1,000 into the typical mutual fund. Given the fund's 0.37% decrease, you would anticipate having roughly $996 in December. You say it could have been worse, but it's not too bad.
Not so quickly, though. In an effort to increase returns, the average mutual fund manager typically sells 92% of the fund's stocks throughout the year. For his extensive trading activities, who is responsible for paying the capital gains taxes? You do. The gains on assets the manager held for less than a year will actually be subject to a higher short-term tax rate.
This implies that instead of using the lower 20% rate applied to long-term gains, you will need to utilise your income tax bracket to determine your bill. When you combine your federal, state, and local tax rates, your tax rate on these earnings may reach 50%.
However, taxes only tell half the story. In addition, a typical mutual fund charges transaction costs to cover the fund's broking costs, yearly fees, and an expense ratio to compensate the fund manager.
Let's go back to the $1,000 you put into the typical mutual fund in January of last year. You would have paid roughly $12 in capital gains taxes and $18 in fees by December. Therefore, rather than losing $3.70 on your $1,000 investment, you lost roughly $30. Compared to the latest 0.37% fall reported by fund-tracking firm Lipper Inc., that is a roughly 3% decline. The average US stock fund's gross return, excluding taxes and fees, is down 0.37%.
"Mutual fund investors should be offended by the amount of taxes and fees they have to pay," O'Shaughnessy asserts. "Investing in mutual funds might seem like a no-brainer, but it may jeopardise your ability to save money over the long run. You might have kept all of your money invested and compounding instead of spending it on fees and short-term capital gains taxes.
O'Shaughnessy has listed five major disadvantages of mutual funds:

high ratios of expenses. The right of owning shares is paid for by investors. The manager of the fund receives that fee. However, the cost is determined by your assets in the fund rather than a fixed sum. Your fee will increase with the amount of money you have invested.
transaction costs that are not revealed. When a mutual fund buys and sells equities, it pays its broker this charge. The fee is subtracted from the fund's returns and is not disclosed in the prospectus. The transaction costs of the fund increase with the portfolio turnover rate.
No command. The equities that the fund owns are not up to you. You might be better off with some stocks than others.
little understanding. You can end up owning the identical stocks in multiple mutual funds as you have no idea what particular assets a fund holds on a daily basis. Additionally, the stocks the fund currently purchases may not be the same as those it initially intended to purchase when you made your investment.
substantial tax penalties. When your fund manager trades equities actively, you pay capital gains taxes as well as "embedded capital gains." These can happen when a fund that you recently purchased sells a stock that it has owned for a long time. Your tax burden from that transaction will be the same as that of someone who invested the same amount but held the fund for many years and benefited from the stock's lengthy price increase.

What should the typical investor in mutual funds do? Alternatives that provide people greater control over their taxes and investments are starting to appear. This emerging "personal fund" industry's Web-based services provide stock portfolios customised to meet the financial objectives of individual investors.
For a relatively small minimum commitment, investors in personal funds purchase a full portfolio of equities rather than shares of mutual funds. You can manage your capital gains taxes by controlling when you buy and sell stocks when you own them in a personal fund. Additionally, you are always aware of the stocks you possess.
When compared to mutual funds and other well-known investment vehicles, people can benefit greatly from the cheap cost of ownership and personal control over tax obligations. As a result, over $1 trillion will be invested in customised funds over the next ten years instead of mutual funds, according to Forrester Research, an e-commerce research organisation based in Cambridge, Massachusetts.
According to O'Shaughnessy of Netfolio.com, "the days when mutual fund investors have to eat what they are served are over." "Personal funds make it possible for every individual investor to own a professionally selected stock portfolio that is reasonably priced and designed for their needs and goals.