There’s one other factor in the mutual fund discussion: taxes.
I’m not talking about the debate in Washington over top marginal tax rates. I’ll leave that to the politicians. What investors need to worry about is capital gains. Active mutual funds buy and sell shares as they manage their holdings. This activity generates gains and losses, and our tax code requires that any realized gains need to be taxed. In order to avoid paying the taxes themselves, the mutual fund companies pass through the gains to their holders.
Funds held in a 401(k) or IRA aren’t affected. Any taxes are paid when the money is withdrawn. But funds not sheltered from taxes are likely to experience “tax inefficiency.” That’s where taxes have to be paid today even if the fund is never sold. It has the effect of raising the cost basis at the expense of negative cash flow. It’s a side effect of high turnover. Many index funds whose constituents tend not to change have less of a problem.
So many folks are drawn to index-based Exchange Traded Funds as their investment vehicle of choice. We use them too. They allow us to manage our taxes, manage our holdings, and own over 3000 stocks around the world in a tax-efficient manner.
Because when it comes to investments, taxes matter. It’s not what you make, it’s what you keep.
Douglas R. Tengdin, CFA
Chief Investment Officer
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