Though it has been some months since most of us have had to think about our taxes, your 1040 may give you some useful clues about how your investments are being handled. The year 2005 was a good year for the equity markets, with most all of the indices up, some substantially so. Unfortunately, that kind of growth can cause tax problems for mutual fund investors.

The mutual fund industry is in the habit of paying their bills with clients’ money. Even the low-cost or no-load funds must pay rent and employee salaries. But if they aren’t charging a commission and their management fees are low, how are they using your money to pay for their expenses? The answer is a sneaky little thing called turnover!

Turnover

Turnover is the practice of a mutual fund manager’s selling stocks and buying new stocks to replace them within a mutual fund. Sometimes this is necessary, as a stock has risen (or fallen) substantially and a manager wants to lock in a gain (or take a loss). However, unnecessary turnover has reached epidemic proportions (industry average is over 100 percent per year) in the mutual fund industry, and some of the most popular “low cost” funds are the worst! Large funds may sell and buy a billion dollars of stock for no apparent reason.

Why should you care? Two reasons. First, it costs you money in fees and reduces the total return of your portfolio. Some of the fees associated with excessive turnover can total as much as 3 percent a year, and you never see it happening unless you compare your portfolio to a risk-adjusted portfolio of index funds or if you get an in-depth cost analysis of your portfolio that breaks out all the costs.

This report can be difficult to find since most retail funds do not like this information to be disclosed.  There are studies out there that can help diagnose the problem.

Taxes

The second reason to care is the capital gains taxes due on profits when a stock is sold to be turned over. Many investors are surprised to learn from their tax preparer that they owed taxes for last year. Why did they owe, you ask? Because there were taxable capital gains distributions from their mutual fund investments.

“But I didn’t sell any of my mutual fund shares,” many investors say. It doesn’t matter. You pay tax on gains your mutual fund manager makes by selling stocks within your mutual fund in order to buy new stocks (turnover) that they think will do well in the future, which may or may not be the case. Studies show it rarely is.

I believe you should not pay taxes on money you did not spend.

Return

The bitterest pill to swallow is that there has never been any academic research that has shown mutual fund managers to be able to consistently and predictably outperform the market as a whole … ever! When compared with appropriate market indices, “active” managers (actively managed mutual funds) fail to outperform the market.

So if you paid substantial capital gains last year and didn’t sell any mutual fund shares, you may be paying a mutual fund manager to gamble and speculate with your money. And worse yet, you’re paying all the cost of turnover-related fees and taxes for them to do it!  In return you’re getting a more volatile portfolio that will consistently under-perform the market.

So take some time and look at your form 1040. It might just be telling you a lot more about how much you owe Uncle Sam.

For an in depth analysis of the fees and costs inside your investments contact your investor coach. You, too, can invest the smart way.

		Jon Bucklin CFP, RFC is an investor coach and managing member of Wealth Management Partners LLC, RIA in Okemos.