So the answer to this question is like most investing questions, it's a bit complicated. The idea of spreading risks across many investments by pooling together investors' money is over 150 years old, and the first modern mutual fund will be 100 years old next year. A mutual fund is an investment that pools assets from shareholders to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund's assets and attempt to produce capital gains or income for the fund's investors. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. Mutual funds give small or individual investors access to a professionally managed portfolio of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market capitalization of the fund, which is derived by the aggregating performance of the underlying investments. Mutual funds come in all different varieties, from active to passive, no-load to loaded funds, diversified funds to sector specific funds, high fee to low fee, etc. Ultimately the goal of a mutual fund is to offer a somewhat simplified approach to investing, at a cost. The last part is important, because some funds can cost much more than others despite investing in very similar underlying investments. It is certainly important to be aware of all costs of a mutual fund, which includes: expense ratio, sales charges, 12b-1 fees, etc. So now that there is some background, are mutual funds good investments for High Net Worth Investors?
Mutual funds do provide the benefits listed above, which can help smaller investors with diversification. As mentioned before, they do offer management of the asset selection to some extent. The next big issue, which is always important to investing, is how about taxes. More specifically, the issue is do you have any control of those taxes?
Unfortunately for investors, most mutual funds do not give you much, if any, control over when and how much tax you incur. With mutual funds you do not have a choice when it comes to taxable capital gains payouts in mutual funds, even worse is that some are short term capital gains (even though you didn't even sell) which are taxed at much higher ordinary income tax rates. Due to turnover (selling) in the fund, redemptions from other shareholders in the fund, gains and losses in security holdings throughout the year, shareholders are required to receive these taxable distributions that are an uncontrollable taxable event to the investor. I have personally worked with investors that have had year-end mutual funds taxable capital gains payouts of over a million dollars, with a significant amount of that being short term capital gains, which again are taxed at ordinary income tax rates. We were able to utilize strategies to help mitigate the tax burden, but it can be quite difficult unless you have significant losses elsewhere. The problem here is that you have no control over these distributions that mutual funds are required to make, which renders any type of tax planning far less than optimal. There is no feasible way to have effective tax planning if you have no idea how much taxable short and long term capital gains are going to be paid out by your mutual funds at the end of each year. So that is one of the big problems, however there is one that is even bigger. The even bigger problem mutual funds cause high net worth investors is that many high net worth investors do not plan on using the assets, yet they will still be taxed on gains over and over. In many situations their goal is to pass the investments on to a family member, beneficiary, or charitable organization who would receive a step-up in basis. This step-up in basis gives the individual inheriting the assets, the ability to not have to pay tax on any previous unrealized gains.
Here is an example of how a mutual fund can impact your tax on an investment that you plan to pass on to a beneficiary. Investor U has an initial investment of $1M in Mutual Fund A, over the next 20 years that fund has grown to $4M, at which time Investor U passes away. Keep in mind, over that time Investor U never needed to use these investments, so he never sold any of the investment over that 20 years. However, over the past 20 years the mutual fund paid out over $2.5M in capital gains that were reinvested, of which Investor U had to pay taxes every single year they paid. As a result, he paid taxes on over $2.5M in gains, so his beneficiary receives very little step-up in basis.
If this investment was in a tax-efficient alternative, the $3M in growth over the past 20 years would not be taxable to Investor U, or their beneficiary. In this scenario, if Investor U was in a tax-efficient investment strategy he would have not had to pay taxes on that $2.5M. In my experience, this example happens to almost every high net worth investor that does not want to look at the options of moving away from a mutual fund that has an unrealized gain, just for the purpose of not realizing that one gain. Instead they elect to continue to hold the investment and have to pay capital gains every single year they continue to hold it. Investors often feel as if they are trapped in a mutual fund because they have accumulated growth and do not want to realize that capital gain. The problem that doing nothing creates is that they will instead have to deal with uncontrollable capital gains for the rest of their life if they stay in that fund. Also, remember many of these uncontrollable capital gains are short term capital gains, which again is taxed at ordinary income tax rates! If you are in this type of situation, it is usually a better option to move on from the mutual fund being able to control the sale as a longer term capital gain, which will be a much lower tax rate. Unfortunately I have seen this too many times, where someone does not look at the big picture.
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