Funds Made Simple

    Exploring Hedge Funds, Individual Stocks, and Mutual Funds

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    Does your investment strategy primarily consist of listening to that guy at your kid’s game who brags loudly about his genius stock picks? Let’s face it – there is something undeniably appealing about the idea of picking individual stocks and striking it rich. I mean, who doesn’t like to daydream about demonstrating how smart they are by becoming fabulously wealthy picking companies that are about to make loads of money? Then selling those stocks at just the right time to lock in their profits! Then buying a Tesla!?

    Look at it like this: Hedge fund managers have used this daydream to their advantage for years and charged 2 percent annual fees plus 20 percent of the profits (think about that for a minute), while generally providing returns that did not exceed standard stock and bond indexes after accounting for their costs. Let’s revisit that: In general, hedge fund managers did not outperform simple stock and bond portfolios, according to a Toronto-based firm CEM Benchmarking analysis quoted in Pensions & Investments at pionline.com. Yet, the allure of exclusivity, inside knowledge, and the like is attractive.

    Beating the market is extremely hard, which is part of why I counsel clients to avoid creating their own stock portfolios. Unfortunately, buying the stock portfolio is only a part of the equation. Prudent portfolio management also requires you to monitor the stocks you buy, make decisions around selling your investments, re-allocate the money you make from said sales, and manage the tax implications as well.

    This is where mutual funds come in, with their ability to outsource the selection, management, and trading of individual stocks. Mutual funds are essentially a basket of stocks that a mutual fund manager decides to buy, monitor, and potentially sell. It is important to note that not all mutual funds are diversified (composed of a broad basket of companies in different areas of the economy), and there is a lot more that goes into creating a properly diversified portfolio besides the number of holdings you own.

    The tax treatment of mutual funds can certainly be an issue for mutual fund investors. Namely, when you own a mutual fund, you are responsible for the taxes the fund manager generates through trading the underlying holdings. If you sell your mutual fund shares at a gain, you are also responsible for the capital gains taxes. This means an investor who decides to hold onto their mutual fund shares during a market downturn may still receive capital gains distributions from the mutual fund as the mutual fund manager trades the underlying assets in the fund.

    Personally, we had the lovely experience of receiving significant capital gains during the 2008-2009 stock market downturn from one mutual fund in particular. This mutual fund experienced a large loss that triggered many investors to sell their mutual fund holdings. These redemption requests forced the mutual fund manager to sell into a downmarket in order to raise cash, which ultimately meant that fund performance suffered even more, as sales put pressure on the prices of the mutual fund holdings and investors received a robust tax bill as well. That was a rough year.

    This is why I prefer tax-sensitive investments and frequently favor index funds or exchange traded funds (ETFs). While index funds may be considered plain vanilla by some, some people also cheer for the Cowboys, and we shouldn’t hold that against them. (Go Eagles!). I prefer to control what I can and make sure I keep as much money as possible invested for the future by avoiding mutual funds with excessive trading costs, turnover, and high fees.

    ETFs generally offer investors a little more control over the taxation of their investments. However, it’s not all smooth sailing. These investments are also baskets of stocks (bonds or real estate investment trusts), but each ETF share trades independently. This means that if other ETF investors want to sell their shares, it could depress the price of the ETF, but the decisions of other investors typically won’t generate taxable income in the form of capital gains for the investor who decides to hold onto her ETF. All interest and dividend income is paid out, but investors rarely receive significant capital gain income, particularly from passively managed ETFs.

    An important point to note is that ETFs do not always trade at net asset value. Meaning, it’s possible to have a discrepancy between the price that the ETF is trading at and the value of the underlying assets. This price-value differential could become quite pronounced during times of market volatility. To minimize this, look for ETFs that have a robust trading volume (that means a lot of people own the ETFs and are buying and selling them every day). ETFs can give their owners a lot of flexibility, as they can be traded all day long (versus mutual funds which only trade at the end of the day).

    As you can see, there are a variety of ways you can invest your money, and we’ve really only scratched the surface. If you have questions about your investments and investment strategy in general, you can sit closer to the guy at the game next week – or you can talk to a professional. The right advisor can help you select the right investment structure to help you minimize taxes and make your plans a reality.