A mutual fund enables investors to “group” their money together in a professionally managed portfolio.
Over 55 million people own them.[1]
Think of mutual funds as a consolidator. They amass revenue from thousands of shareholders into one investment pot (or portfolio).
But mutual funds, which in some ways can simplify investing, aren’t without complexity.
That’s because, first, short-term capital gains realized from mutual funds are taxed as ordinary income.
If you’re one of the 55 million who are invested in an independent mutual fund [as opposed to one that’s part of a model portfolio, or a retirement account such as a 401(k)], you might’ve received a capital gains distribution.
That certainly doesn’t sound like a bad thing. And, at a glance, it isn’t.
But, if you’re not careful, you could find that, when it comes to those gains, the taxation and regulatory landmines can be big, expensive hassles.
That’s because, first of all, the timing of distributions from funds are out of your control. This makes them sudden, taxable events.
Briefly, when a mutual fund manager liquidates stocks or securities, or when interest is earned from the fund’s holdings, you’ll (after operating expenses are paid) receive a payment (or what is known as a distribution) for those gains.
Distributions come from the profits of the mutual fund’s operation. And because mutual funds are considered “pass through” investments, the fund managers are obligated to give 95% of the “realized” gains back to investors.
This is different from, say, owning shares in an individual company that can choose to reinvest the profits or even return those profits to shareholders as “dividends.”
But, unlike individual stocks, things can get a little complicated when it comes to mutual funds.
If an investment inside the mutual fund is sold in the first year you’re a part of it—even an investment the fund has owned for years and years—you’re not only taxed on that income at high short-term capital gains rates, you’re taxed on the appreciation of that investment as though you’ve owned it for as long as the fund has.
A second issue with mutual funds is that your Investment may actually lose considerable value due to profits realized before you were involved.
Of course profits are preferable to losses.
However, if you’ve only owned the fund for a short period, and the managers decide to sell the shares of a valuable company, the large distributions to long-term fund owners may leave the fund’s “net asset value” seriously depleted.
This lessens the purchasing power and diversification of the fund you’ve invested in.
A third issue with mutual funds has to do with regulation.
Mutual funds pool resources from thousands of investors. Because investors come and go, mutual funds have to keep a lot of cash available for withdrawals.
And all that cash just sitting around is not being invested nor earning returns for you.
Conclusion
Remember, all investments carry risk.
Mutual funds, with their resource “pooling,” have appeal for certain investors. That’s because:
- They can simplify the investment process
- They can provide easier access to complex investments
- They can enable people without a lot of resources to invest
- And, ideally, they emphasize diversification, which should help protect investors
For more information about investment vehicles that are appropriate for you, please contact us today.
[1] Investment Company Institute February 24th, 2017
