Investors find mutual funds arenít always tax-friendly

McClatchy-Tribune Information Services

June 20, 2016

PITTSBURGH ó Many mutual fund investors were baffled this year to get a tax bill for mutual funds they owned that may not have even earned any money last year, and that has a lot to do with the disconnect between the way mutual funds operate and the actual returns that shareholders reap.

"The most common risk people think about in investing is the risk that their principle could go down in value and the risk of purchasing power going down when it comes to inflation," said Robert Hapanowicz, president of Hapanowicz & Associates in Pittsburgh.

"Another risk is the effect of taxes on the returns of your portfolio."

And stock mutual funds may not always be tax-friendly.

Mutual fund managers are constantly buying and selling securities within the fund. They must pass along to shareholders any realized capital gains that are not offset by losses by the end of the accounting year.

Thatís one reason an investor should never buy into a mutual fund just prior to a capital gains distribution, which typically occurs in December.

Although the nationís stock markets saw low or even negative returns last year, mutual funds had already carried forward the losses sustained coming out of the financial crisis and used those to offset the substantial gains they were earning in 2013 and 2014. By 2015, fund managers had few if any losses to offset gains, which resulted in shareholders receiving larger taxable gain distributions even though they may not have made any money.

While mutual funds are the reigning heavyweights of the financial services industry, exchange traded funds (or ETFs) that track small nooks and crannies of the investment world are gaining popularity. Thatís partly because ETFs can be more tax-efficient compared to mutual funds.

According to the Investment Company Institute in Washington, D.C., total ETF assets grew from $1.1 trillion in 2012 to $2.1 trillion as of March 2016.

Mutual fund assets, on the other hand, grew from $13 trillion in 2012 to $15.7 trillion in March.

"Itís the investorís decision when to sell an ETF and pay taxes as opposed to paying taxes at the whim of a mutual fund manager," Hapanowicz said. "ETFs put investors more in the driverís seat regarding when capital gains are realized and therefore when they pay the taxes."

Exchange traded funds try to replicate the performance of a stock market index, such as the S&P 500, the Russell 2000 or a market sector, such as energy or technology. Similar to mutual funds, exchange traded funds offer investors partial ownership of an undivided pool of stocks and other assets.

The main difference between the two comes down to how they operate.

When an investor sells shares in a mutual fund for cash, the fund manager must sell some of the fundís holdings to raise the cash to pay the redeeming shareholder. Those transactions have tax consequences and if they result in a gain, the gain must be distributed to all shareholders.

ETF managers need not sell assets to settle sales. The fundsí shares are sold on an exchange, essentially from investor A to investor B.

While exchange traded funds have advantages ó especially when it comes to taxes ó a mutual fund will give investors a chance to outperform the market because mutual funds are actively managed, said Nicholas Besh, senior vice president and investment director at PNC Wealth Management in Pittsburgh.

"Also, mutual funds can use techniques to offer a better risk-adjusted return," Besh said. "Mutual funds can use hedging techniques or diversify so that volatility is less. With an ETF, it holds whatever it holds and there are no changes.

"Itís hard to say one is better than the other and many investors use both in a portfolio. I personally recommend using both."

P.J. DiNuzzo, chief investment officer at DiNuzzo Index Advisors in Beaver, said his firm, which specializes in retirement income planning and index investment management, has $525 million under management and all of it is invested in index mutual funds and ETFs.