Tough Tax Year Ahead
SmartMoney reports that mutual fund investors are in for a tough April 15th. Taxes paid by mutual fund investors, muted for years by the big losses of the early 2000s, are back with a vengeance:
Fund industry experts are predicting a double whammy this year that we haven't seen since the tech bubble burst. Not only will investors be staring at flat or dismal returns, but they'll also be faced with paying taxes on big capital gains distributions from the well-performing funds they held before the recent turmoil began. Lipper senior research analyst Tom Roseen estimates that investors may pay 20% to 30% more to the federal government than the $24 billion they shelled out last year. That means the typical investor, depending on how much they've saved in certain funds and what type of an account that money is in, could face a tax bill of thousands of dollars. 'We could easily hit the highest tab investors have ever seen,' says Roseen."
By law, funds have to distribute any taxable gains from investing to shareholders each year.
Your fund has profits and losses much like your own portfolio does. Funds can have losses from bad investments, gains in the form of short term or long term capital gains, ordinary income, and now, low tax dividend income.
Each year the fund accountants figure out how much income there is of each type. The tax liability is then passed on to the shareholders in the form of a dividend (the tax rate for each depends on the shareholder), which is why none of this matters in a tax deferred account like an IRA or 401(k).
Most of these fund distributions are made in December and many fund companies give estimates of these distributions on their websites in late November and early December, which can help existing and potential investors avoid some taxable gains.
See also:
Tougher Tax Times Ahead for Mutual Fund Investors
New Look and Features on MAXfunds Data Pages
We're happy to debut our improved mutual fund research pages today.
We've added over fifty new data points, most of which are accessible by clicking the 'Show Details' link you'll find at the bottom of the Expenses, Performance, MAXmetrics, Portfolio and Resources sections.
If you have any comments or if you spot a bug, please let us know by clicking here.
Will The Government Bail Out Fannie and Freddie?
This morning cutesy-pie named “Freddie Mac” (FRE) scared investors with the news that the company’s third quarter loss was just a smidgen over $2 billion, and that they might cut their dividend for the first time ever - by as much as half. Freddie Mac is Federal Home Loan Mortgage Corporation, own of two giant government sponsored entities at the very center of the mortgage storm. Fannie Mae (FNM), or Federal National Mortgage Association, is the other.
Both stocks opened down sharply this morning – continuing a slide that started a few weeks ago but well after the mortgage market started melting earlier this year.
Investor’s confidence in the wonder twin’s power to avert trouble amidst the collapsing lesser giants like Washington Mutual (WM) and Co untrywide (CFC) could best be summed by CNBC’s David Faber on "Squawk on the Street” this morning at the opening bell:
…don't know if we have a bid/ask [for Freddie] but it’s looking below $26 dollars a share down over $11... It’s not like Freddie is going to get taken out here or anything in terms of any problems. The government will be there at some point."
Perhaps the government will “be there at some point” when things go awry, but does that mean the government will support the shareholders of Fannie and Freddie? Would there not be outrage by taxpayers (some renters surely) stuck paying hundreds of billions to support the mortgage market – a crisis of S&L bailout proportions – AND shareholders including Fannie and Freddie executives with millions worth of stock who drove the car off the cliff?
In the great real estate bubble, all roads eventually lead to Fannie and Freddie. This may be bad news for shareholders of many large cap value funds with big Fannie or Freddie stakes, notably two Weitz offerings: Weitz Value (WVALX), down 1.38% today, or Weitz Partners Value (WPVLX) down 1.18% on a day the S&P 500 was up slightly.
Islamic Funds Outperforming
Carolyn Cui at the Wall Street Journal reports that mutual funds that invest in accordance with Islamic doctrine have been among this year's top performers. This outperformance is in large part because Islam forbids charging interest; funds following these rules have avoided investing in banks and mortgage companies that have been hard hit by the sub-prime meltdown. In fact, of the nine broad sectors in the S&P 500, only two are negative this year: financials and consumer discretionary.
Most mutual funds that invest based on Islamic principles have largely weathered the recent credit turmoil. Two Islamic funds offered by Azzad Asset Management, smaller than the Amana and its $333.1 million of assets, also are beating the Standard & Poor's 500-stock index since the start of this year, after trailing the broad market for several years.
Dow Jones Islamic Fund is up 13.3% year to date, which ranks it in the top 4% of its category of large- market-capitalization stocks. The fund, managed by Allied Asset Advisors, tracks the Dow Jones Islamic Market Index, which is a product of Dow Jones & Co., publisher of The Wall Street Journal.
A sister Amana fund, Amana Growth Fund, isn't doing quite as well. The fund has $680 million of assets and invests in companies whose earnings are expected to rise faster than the broader market. It has returned 11.5% this year. While that beats the broader market, it still trails its growth-type peers by 1.4 percentage points."
The chart-topping performance of the two Amana funds has apparently attracted plenty of non-Muslim investors as well. As the article states, assets in the funds has ballooned to $1 billion in the past 18 months.
Less is More
In a move that would have been timely about a decade ago, the Securities and Exchange Commission is 100% in agreement to think about ways to help fund investors compare funds.
Under the proposed changes, investors would receive a summary of information about a fund, on paper or electronically, depending on their preference. The SEC also proposes encouraging mutual-fund companies to make greater use of the Internet, giving investors the choice to request a printed copy of the full prospectus or obtain more-detailed information online.
The SEC will seek public comment on the proposal for 90 days. Adoption of any changes requires a second SEC vote."
Pretty soon we should see summary info about funds online and maybe companies like Vanguard will have websites to compare their funds. It’s just amazing what The Internets can do.
Capital Gains Questions?
Mutual fund coverage at The Motely Fool is, to put it mildly, hit or miss - but today they post a nice explanation of what is a confusing issue for many fund investors: capital gains distributions.
When a capital gains distribution is made, the fund's value is adjusted downward accordingly. If you buy just before the distribution, you'll face taxes on an investment you didn't own for very long -- and in many cases, one you never owned. Funds often wait nearly the entire year before paying out gains from a sale early in the year."
The article lists several legitimate techniques you can use to minimize your capital gains exposure, including buying funds with high capital gains potential through non-taxable accounts like your IRA and investing in ETFs (which aren't subject to capital gains distributions).
One note: unlike most fund reporters and analysts (including the author of The Motley Fool's article) we are not big fans of reinvesting dividends in funds held in taxable accounts unless the fees to buy other funds with the distributions are excessive (loads, commissions). It can be very difficult to determine your cost basis later when selling after random reinvest points determined by fund distributions. We prefer putting the cash from various fund distributions into new funds, or to rebalance your current stock / bond / cash stake.
Stable Value – Good Or Bad for 401(k)s?
Stable Value funds are low risk choices in many 401(k)s. The funds create the illusion of stability by owning bonds and getting some big insurance company to eat any fluctuations in the fund’s price that result from bond prices changing when interest rates move.
Stable value funds tend to benefit investors over more traditional bond funds when interest rates rise sharply, but underperform when rates fall. But creating the illusion of stability isn't free, and you can expect stable value funds to underperform low fee bond funds over long periods of time.
The insurance industry has done a good job of getting this product into 401(k)s (where they now represent around 10% of all plan assets). Unfortunately for the insurance business, stable value funds are not going to be allowed in new automatic enrollment choices – the plan to opt in employees to their 401(k) as if they actively took steps to save. Apparently the labor department would rather see young investors splurging on stocks with a traditional bond chaser than use the nervous nelly stable value choice. Looks like the fund lobby beat the insurance lobby on this one.
A recent WSJ article notes the usefulness of stable value funds in 401(k)s:
But others say these funds, which are hybrids of fixed-income investments and insurance policies and are found in 401(k) plans and other retirement accounts, can have a place in a portfolio's conservative corner. They offer a good parking place for money that may be needed soon and may also work as a substitute for cash or as a holding for extremely risk-averse investors…
In some ways, they are similar to bank certificates of deposit. They aim to protect an investor's principal, and offer a yield that's typically at least a percentage point higher than that of a money-market fund with less volatility than a short-term bond fund….
We’re not so sure the portfolios of stable value funds are as rock solid as everyone thinks. Some of them might have invested in some once top investment grade mortgage debt that has suddenly fallen far down the bond quality totem pole. Unlike CDs, they are not guaranteed by the U.S. government.
In general we prefer low fee short term bond funds or money market funds for the safe yield allocation in a 401(k). Unfortunately sometimes stable value is the only safe choice in a 401(k) plan, or the bond or money market fund choices are expensive and crappy.
One oddity – why are ordinary super safe bank CD’s not in 401(k)s for a similar deliverable: no volatility and no risk?
Perplexed about ETFs?
According to InvestmentNews, most investors don't know the difference between a mutual fund and an exchange traded fund.
a recent survey of 500 individual investors by Rydex Investments of Rockville, Md., found that 53% did not know the difference between an ETF and a mutual fund. Thirty-eight percent of those surveyed didn't know what an ETF is."
Well here's the short answer: the key difference between an ETF and a mutual fund is that it can be bought and sold throughout the day (and can change in value throughout the day), like a stock. A mutual fund is priced just once, at the end of each day.
There are other differences between ETFs and mutual funds - like ETFs are not actively manged unlike most mutual funds. Some of the features investors find attractive about exchange traded funds are their low fees and a fund market price that, because of a complex arbitrage system, doesn't vary much from the actual fund NAV (or net asset value), a key shortfall of the other exchange traded funds: closed end funds.
Janus Fund Manager To Step Down
Marketwatch reports that Janus Fund (JANSX) is getting a new manager:
David Corkins, a 12-year veteran of Janus and manager of its flagship Janus Fund (JANSX) and other large-cap growth stock-fund vehicles, will leave the Denver-based company effective Nov. 1."
The Janus fund has posted better returns than a large cap growth index and similar funds since early 2006 when Corkins took over management, so his departure is not due to unsatisfactory performance, but rather that old Janus internal management turmoil that we used to know and hate (Janus recently announced that Scott Schoelzel, manager of Janus Twenty's [JAVLX], will be leaving at the end of the year). Maybe Corkins has his eye on a big hedge fund salary.
It's a good idea for owners of a fund that has changed management to keep a close eye on their investment. Bringing in a new manager to a mutual fund is kind of like starting a new quarterback in the NFL: investors are hoping for a hall-of-famer like Tom Brady, but they might end up with a washout like Ryan Leaf. New fund management can bring a entirely different investment approach, so much so that you could look at the Janus Fund after November 1st as an entirely different investment than the one it was under Corkins.
In this case we don’t think there is going to be a change for the worse here – we like the new managers and have other funds they manage in our MAXadvisor Powerfund Portfolios - but you can expect our ratings for the Janus Fund ratings to change slightly here in coming months (fund manager turnover generally hurts our custom quantitative ratings).
Jaffe's Lumps of Coal
Sure Chuck Jaffe's Christmas-themed 'Lump of Coal Awards' might not be as clever or insightful as our own Thanksgiving focused Turkey Awards, but they're an entertaining pre-holiday week read nonetheless.
We especially like his 'Inability to Recognize a Bad Fund When They See It' award giving to the directors of the Franklin Real Estate Securities Fund:
Franklin Real Estate Securities is off more than 20% this year, but even when this fund has made money, it has badly lagged its peers. Directors acknowledged as much in the fund's annual report, noting that "the fund's total return for the one-year period, as well as for the previous three-, five- and 10-year periods on an annualized basis was in the lowest quintile" of its peer group. That's putting lipstick on a pig, because the fund actually ranks in the bottom 5% of its peer group for all of those time periods, according to Morningstar.
Adding eye-liner, a party dress and a suggestion that this pig will dance, the very same paragraph said that "the board found such performance to be acceptable."
Of course, the real travesty with a poor performing giant fund is not with their boards (how many fund boards really care about lagging performance anyway?) nor the semi-blind shareholders, but with the brokers who sold it. No load funds almost always shed assets when performance slips – even long time winners will lose shareholders after a few bad quarters. Until absolute returns tank hard, load funds can maintain a healthy, commission paying, asset base in near perpetuity.
That said, this fund has recently seen mass shareholder redemptions, which should cause a huge taxable distribution to the remaining shareholders when the fund goes ex-dividend tonight. Talk about dammed if you do, dammed if you don’t – either sell the fund and possibly owe a back end sales load (C,B class shares), or stick around and get hit by some other investor’s taxable gains in a year the fund is down by double digits.
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