If You Own Mutual Funds, Read This Immediately

 
If you hold mutual funds, you are losing money that you don’t need to be losing due to the way they are structured.
 
If we designated mutual funds with a number similar to what technology companies call their software versions, mutual funds could be considered “Version 1. 0.” The mutual fund structure is almost 100 year old technology. Some wine connoisseurs make the argument that certain wines get better with age, the same cannot be said about the mutual fund structure.
 
Why haven’t you heard of this before?
 
Because there are billions of dollars in management fees, research expenses, and trading costs that Wall Street would rather you not focus on.
 
Structurally, mutual funds are not efficient.
 
Are you aware that your neighbor down the street who you never talk to can directly affect your taxes?
 
Yep. When you neighbor sells their mutual fund position the mutual fund manager must sell the underlying positions in the mutual fund to raise cash to then send to your neighbor. And since the fund sold the underlying positions to raise cash, if there was a gain, this gain can be passed along to you in the form of a taxable gain even though you didn’t sell your position.
 
If this sounds a bit archaic, that’s because it is.
 
You might ask, there has to be a better way? And you’d be right, there is a better way.

It’s called an Exchange Traded Fund or ETF. I would call ETF’s the software equivalent of at least version 2.0. They are structurally completely different than mutual funds, but from an investors perspective they are effectively the same. They can hold a basket of securities (US stocks, foreign stocks, corporate bonds, commodities, US treasuries, etc.) just like mutual funds and allow investors to purchase and diversify very easily.
 
A recently released Goldman Sachs paper reported that in 2019:

• 54% of mutual funds paid-out capital compared to just 7% of ETFs.
• Mutual funds paid an average of 2.4% capital gains while ETFs were at just 0.1%. This equates to mutual funds paying out 24x times more in "capital gains" which then translates to mutual fund holders paying substantially more taxes than their ETF cousins.
• Only 11% of ETF trades affect the underlying portfolio and instead the vast majority of trades occur between market participants such as investors and dealers; in open-end mutual funds, 100% of activity takes place in the primary market and affects the underlying portfolio. 

By using ETF's instead of mutual funds, investors can better control when they pay taxes, or in other words, pay when they sell their shares rather than when their neighbor (i.e., other shareholders) does. 

Similar to an iPhone software update, it's time to update your investment software. 
 

-Paul R. Rossi, CFA