In yesterday's Wall Street Journal, Tom Herman reminded us of one of our now-standard subjects: The woeful tax inefficiency of many open-end mutual funds. (See this April item for more from us on this problem.) Here's Herman's introductory take:
For most mutual-fund investors, it's been an abysmal year. The average U.S. diversified stock fund is down 33% through Monday, according to Morningstar Inc. Foreign stock funds have also posted steep declines, as have funds in most other categories.
And some investors may have to pay hefty tax bills on their losing funds anyway.
Much of Herman's advice is perfectly spot-on: Be aware of record and distribution dates, consider offsetting any gains with realized losses, &c. Our objection isn't with Herman. It's with the premise of using actively-managed open-end funds in taxable accounts in the first place. Here's a quotation from Greg Hinkle or T. Rowe Price:
"In markets with big daily moves, keep investment considerations foremost. If you stay out of a fund for one day to avoid a 5% distribution, but lose out on a 6% or 7% upward market move that day, you've lost ground."
Fair enough, but wouldn't it be much wiser still to participate in particular asset classes using vehicles that don't (generally, with vanishingly few important exceptions) suffer from these absurd tax implications? Consider the experience of the investor who unwittingly busy shares of the Oppenheimer Developing Markets fund, which Herman tells us will distribute roughly 20% of its net asset value in December. Ouch! Fund complex to investor: "Thanks for your $20,000 investment in our fund. Now, here's $4,000 of your money back. Capital gains taxes are due April 15th. Please consult your accountant."
Prudent taxable investors will consider establishing asset-class exposure with the obvious alternative: Inexpensive exchange-traded funds, which, due to their creation-redemption process, distribute vanishingly few (in fact, almost always no) capital gains.
Tom Herman, "Fund Investors Face Risk of Tax Hit Despite Losses," Wall Street Journal, October 22, 2008