Why Mutual Funds Suck

The first US based Mutual Fund was created in 1924, called MITTX.  The theory was that it allows an investor to buy a broad array of stocks without having to buy 1 piece at a time.. IE it makes diversification affordable. Great idea.

Both active and passive funds hold stocks which are traded by the fund’s manager, in the active variety it often involves using a crystal ball and a quant team to predict the future, buying and selling stocks to create magical Alpha for their investors (spoiler alert, they typically don’t).  Passive funds seek to track an index, so the fund managers of these have to mimic movements in the market in order to keep their fund in check with the benchmark index it is designed to follow.  The success in doing so is measured by the ‘tracking error’ statistic.

Typically, a passive fund will have less trading, as it tends to gently steer the ship to keep it on course, vs sharp chops and changes of the active fund.

Other events also cause trading transactions, such as investor inflows/outflows, and changes in fund manager or strategy.

What all that trading does

All those buy/sell transactions, either based on witchcraft or ensuring the tracking error doesn’t get out of control creates capital gain (and loss) transactions. Mutual Funds are required to pass this on to the funds holder of record, the distribution will come to you in the form of a cash payment, and also may be taxed in several different ways.  Essentially you are receiving a dividend.

Qualified vs Non qualified dividends

Qualified dividends are taxed at capital gains rates (IE lower than Ordinary income) whereas Non qualified dividends are taxed at your marginal income tax level.  Dividends become non qualified when generated in certain circumstances when it comes to mutual funds:

1. Short Term Cap Gains – IE when the fund trades quickly (under 1 year buy/sell round trip) in order to stay on track.  Note that short term cap gains are taxed at ordinary income rates anyway, so they are just saying you can’t escape that here.
2. The fund receives dividends that are non qualified (by capturing the dividend on a stock, and selling it before a 61 day period has elapsed)
3. Taxable interest – when passed on to the holder of the fund, this will be a non qualified dividend.

Also, it is worth noting that your qualified dividends from the mutual fund will themselves be recategorized as non qualified if you hold that fund less than 61 days (derived from the same rules as point 2 above).

Why mention this now?

If you hold mutual funds in a taxable account, you are about to get that distribution.  It can involve taxes at short term rates, even if you have held it for the long term.  You might wonder why you’re invested in these funds anyway?  Chances are someone at your local bank or credit union suggested that they were a good idea, because (just like in 1924) they allow you broad access to the market at a low entry point.

They likely don’t mention how much they earn from selling them to you, or how that compares with other options that create the same diversification goal.

Note, not all mutual funds are atrocious in terms of fees (but many are!) but they all are treated for tax purposes in this way. And it just isn’t smart to generate inadvertent taxable income from the trades that your investment managers are making.

Here’s a broad generalization:  ETFs tend to be passive, and mutual funds tend to be active.  They don’t need to be, but you’ll simply find more active funds in mutual fund form.  As such, if you want a broadly smarter way to get into the market, and avoid the distributions from the funds, ‘generally’ you’ll have better luck finding those within ETF format.  

That’s not to say that there aren’t some good passive, and active mutual funds out there too.. and I know the above is a broad generalization, so here’s another: it is a LOT easier to find active mutual funds chock full of fees to pay commissions to brokers than it is to find them in ETFs.