The majority of mutual funds underperform the market.
End of story, right? Time to move on to the next investment vehicle?
Not quite. There is a reason why hundreds of billions of dollars are invested in mutual funds. Mutual funds themselves are actually a great, convenient way for people to invest in a diverse portfolio of stocks and bonds, managed by a professional at the expense of a yearly fee. But why do mutual funds fail to beat the market the vast majority of the time?
The hardest job a fund manager has is to beat the annual fees. Outperforming the market itself is not an easy task. However, it takes a spectacular manager to outperform by over 1% or 2% on a consistent basis and justify their pay.
Luckily, there are quite a few out there.
The trick is to look beyond short term performance and asking a broad spectrum of questions. Before jumping into a fund, learn about the manager, his investing style, the fund's history, its strategy, how consistent has it been with its strategy, volatility, and of course fees.
If you are able to pick a good mutual fund, it comes with a wide range of benefits. Not only do they provide instant diversification, they also open up new areas to invest in. As an individual investor, it is extremely hard to get a hold of some stocks from Brazil or South Africa or Hungary. Perhaps, you are looking to hold some high-yield Chinese corporate bonds. Mutual funds open up the possibility to more exotic investments.
But while timing the market is near impossible, timing the mutual fund is incredibly easy.
As the final stretch of the year comes up, maybe you know someone who is thinking about investing in a mutual fund. While the general idea is that you can never get started too early in investing, beware of buying a distribution and footing a costly and unnecessary tax bill.
When a mutual fund manager sells a stock, he incurs short-term and long-term capital gains. Combined with any dividend and interest payments received, mutual funds are required to distribute the year's income to the fund's investors. However, mutual funds themselves do not pay any income taxes, which means that the fund's shareholders are left holding the tab.
Many mutual funds distribute the year's net investment income towards the end of the year. At first glance, it might seem like a cunning move to jump in just before mutual funds pay out their annual income. But analogous to dividend-paying stocks, if the mutual fund pays out $1 per share, the share price will drop $1, leaving your total net worth unchanged.
A quick example:
If you invested $10,000 in a mutual fund at a per share price of $10, you would receive 1,000 shares. If the fund then distributed $1 per share the next day, you would hold $1,000 in cash and the share price of the fund would drop to $9, leaving your position in the fund at $9,000 but overall you still have the same $10,000 you started with.
However, the IRS sees things a little differently. The payout gets reported and taxed even if the distribution gets reinvested. So you end up being taxed for something you didn't even earn and end up worse off than you started. In the earlier example, the $1,000 would then be recognized as income and taxed at the short-term capital gains rate. If you fall in the 25% bracket, then you will end up paying the IRS $250, leaving you with only $9,750 or down 2.5% before anything substantial even happened.
This is the key reason why you should avoid entering a mutual fund towards the year-end, when most funds have set their ex-dividend date. Before buying any mutual fund, research when the next payout will be, and plan accordingly. Remember, taxes can have a huge impact on what the final, realized return will be.
