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Going to Buy Mutual Funds in a Taxable Account Soon? Beware of This Tax Trap

For those interested in buying mutual funds before year-end, be careful because you may end up having an unintended tax bill because of it.

The reason is that mutual funds are required to distribute capital gains and income on an annual basis; many stock funds choose to do this all at once at the end of the year. Distributions are subject to federal and state income taxes if held in a taxable account. So for example you invest in a stock mutual fund, it makes a year-end distribution the next day, the distribution is reinvested and the dollar value of your investment remains the same. Even though you didn't make money on the investment, you end up paying taxes on the distribution amount. In other words, you're being forced to pay taxes on your original investment.

With the bottom of the bear market four years ago, many funds have exhausted their losses and are expecting larger payouts. How do you avoid the trap? If you are interested in buying a mutual fund, check out the funds website or call the fund company directly. Many of these funds have become very helpful in disclosing their distribution dates and expected payouts. Once the payout is known, make the purchase after the distribution date. And to reiterate, this only involves taxable accounts, not tax advantaged accounts such as Roth and Traditional IRA's.

By taking a little extra caution, you can avoid some erosion on return that taxes incur. And it's a whole lot better than paying taxes on something that you didn't make any money on in the first place.

Where Did Our Energy Crisis Go? A Look Back to What I Said Last Year

Periodically I write about hot button issues from the current events of the time; differentiating the hype from the substance. Energy prices seem to be the perpetual lightening rod that American’s love to cling to. In light of filling up my tank at prices 33% below last year’s peak just the other day, I pulled the following entry below out of the archives. Written right before Hurricane Katrina, I got some heat for it (somebody actually claimed they were offended, another claimed that I was an advocate for the oil industry). In the end, I still feel this entry holds just as much substance today off of energy’s highs as it did back then. A commodity is cyclical in nature; it can’t create a secular bear market or ruin an economy. And in the end, another spike in energy prices will happen, it’s inevitable. But we shouldn’t panic. Every commodity bubble will eventually pop and I it appears that we are beginning to experience this now. For those who were frustrated and upset with what I had to say then, maybe you will be able to rationalize it better this time around.

The entry below was written on August 31, 2005:

The New Unfounded Crisis: Oil Prices

Like clockwork, the media continues to promote the next crisis. Fear sells and there is always something to worry about, but the economic apocalypse never comes. Anyone remember the jobless recovery, the bear market that we never would get out of, or the world meltdown of computer systems on Y2K? That was the panic of the past. Today it's oil prices.

First of all, put things in perspective. You hear all of the news about record prices; that's in nominal terms, not inflation adjusted terms. Oil has actually lagged inflation over the last twenty five years. If oil increased with inflation since its peak of $38 per barrel in 1980, it would be approximately $97 per barrel today. With oil around $70 a barrel, we still have a long way to go. How about gas? Gas peaked at $2.94 a gallon in today's dollars back in 1981 and we are a bit closer to that mark. The ramifications of hurricane Katrina may push us closer to inflation adjusted high's, but we are still in line with prices in real terms. So the daily reports sounding the news of record shattering prices is a slant on the truth.

Second, oil is a cyclical commodity. Commodities do not send economies on a perpetual tailspin. They follow the flow of a cyclical up and down pattern. It certainly can slow down an economy; not necessarily a great scenario, but it can't create a recession or the end of days. The natural law of supply and demand balances out in the long run. When oil was steadily in the low $20 range, there was no economic incentive for producers to find and create additional supply. And there was no need for consumers to conserve when gas was so cheap. But with oil around $70 per barrel, this changes everything. Suppliers have economic incentive to re-open shuttered wells that weren't productive before, expand refining capacity and transportation, develop technology to find and extract reserves efficiently, and the incentive to find alternative sources of energy. Consumers speak with their wallets. Gas guzzling SUV's will diminish in vogue, energy efficient vehicles and heating will gain popularity, and people will become more frugal with their consumption.

Don't get me wrong; I hate filling up the gas tank as much as anybody as my household commutes roughly 90 miles a day and I'm certainly not rooting for prices to go higher. But think about it. If I told you back in 2002 that oil prices would more than triple, you would think this would be catastrophic to the economy. That hasn't happened. Matter of fact, the breakout in oil prices may be the healthiest thing that has happened to energy for quite some time.

Recent Article Highlights Potential Conflicts At Fidelity

The financial services industry is notorious for having inherent conflicts of interest. And a recent article in October 16th edition of Business Week highlights a potentially significant one at Fidelity.

In the article Fidelity’s Divided Loyalties by Roben Farzad, the article points out that Fidelity owns a 10% or greater stake in at least 100 out of the 1000 largest U.S. companies. Although it has the power to push for better corporate governance, the company over the past several years has tended more often than not to side with management. And the article questions if this tendency is influenced by the relation that Fidelity has as a vendor to these companies.

The article goes on to highlight one example involving Analog Devices. The firm is currently involved with an options backdating scandal and is under investigation from the SEC. The stock has declined significantly since this news became public. Fidelity and T. Rowe price are equally the largest shareholders in the company. Earlier this year in their proxy voting, T. Rowe Price withheld its vote for the only member of the compensation committee that was up for re-election and voted against management for a proposal that was initiated by shareholders. Meanwhile, Fidelity voted for all directors and against the shareholder proposals (coincidently, two Fidelity index funds that are run by outside companies and vote their own proxies voted against two management proposals).

On the surface, it appears to be no big issue. But Fidelity also manages Analog’s 401(k) plan. And the article calls into question if Fidelity’s vendor relationship might have influenced their decision at the expense of shareholders. And for shareholders of Fidelity funds, I think it is something to be very aware of.

Proponents Of Higher Federal Taxes: Be Careful For What You Wish For

When tax cuts were enacted in 2001 and 2003, the opponents claimed that this would spiral our federal budget out of control. Their claims appeared to be justified as in 2004, the federal budget deficit stood at $412.5 billion, up from $159 billion in 2002. But a funny thing happened after that; the federal budget deficit now stands at $247.7 billion. As compared to GDP this is well below the historical norm over the past 40 years. So what happened to the doom and gloom that the anti-tax cut proponents predicted?

Tax cuts should have resulted in lower tax revenue, right? Wrong. The federal government has just experienced the largest two year inflation adjusted tax revenue increase in history. The charge has been led by over a 76% increase in corporate tax revenues. Personal income tax has increased 30% despite the lowering of marginal tax brackets and cuts in dividend and capital gains. These tax cuts along with easing monetary policy were widely credited for bringing us out of the economic slump after the tech bubble burst; ironically, lower taxes created higher revenue (Augusta, take note).

So why isn’t Congress bringing this up? Follow the spending. Last year alone, the federal budget increased 9% and has increased more than 49% over the past six years. Even beyond the cost of having a war on terror and rebuilding after Katrina, our deficits would have significantly improved if Congress had one iota of spending constraint.

The problem with Congress (or any legislative branch of government) is that spending is their innate power and they like to wield that power. They don’t like it when that power is taken away. So for any candidate who is in favor of raising taxes, I will have to ask, “Is it to prudently manage our federal deficit or because you want to spend it?”

In the end, raising taxes is not the solution and I would hate to see where our economy would be now if tax cuts were not enacted; the “jobless recovery” mantra we heard about a few years back probably would have come true. Now with the Federal Reserve tightening monetary policy and the subsequent slowdown in the economy, we need higher taxes just like we all need another hole in our heads.

Quick Tip: Three Tax Breaks that May Totally Disappear for 2006

If you used these three tax deductions in the past and are expecting to use them in 2006, you may be in for an unpleasant surprise.

Over the past few years, several new deductions were created that officially expired in 2006. These breaks are:

1.) Deduction for tuition

2.) Deduction for teachers who buy classroom materials

3.) Deduction for state and local sales taxes

All three of these deductions were expected to at least be extended, but were part of the failed “trifecta bill,” that was packaged with the estate tax cut and minimum wage hike.

At this point, there is still hope as a lame duck session of Congress could move forward and extend these breaks. But this may create its own set of problems as these deductions could be passed after the IRS prints the 2006 tax forms. So even if this legislation is passed, you may have to wait until the updated form is printed and available and/or updated in your tax software program. So if you are eligible for these tax breaks if they are extended, I would kept abreast of what goes on over the next few months prior to filing your tax return by going to the IRS website periodically.

Hype or Substance: Hedge Funds

In my entry last week, I discussed if Separately Managed Accounts (SMA’s) were a viable investment alternative or just cache. This week I’m going to discuss another intriguing investment vehicle that has gotten a lot of hype over the past few years: the private hedge fund. Private hedge funds are loosely defined as any unregistered, privately offered investment vehicle. They are exempt from many of the regulations afforded to mutual funds, giving these funds the flexibility to employ a wider variety of strategies such as the use of leverage, arbitrage, or short selling. Hedge funds have many specialties such as merger arbitrage, distressed securities, market neutral, global macroeconomic and a variety of other approaches. When many people think of hedge funds, they think of the exclusiveness and of market beating returns. But do these investments deliver? These are the big concerns I have with hedge funds:

1.) Hard to get in the Door: First of all you need to be an “accredited investor” who meets certain income or wealth requirements. And then you need to have the money as minimum investment requirement, which can be $250K or more. There are registered hedge funds or funds in which a individual manager invests in several private hedge funds where you can get in for as little as $25K to $50K. These hurdles usually make it difficult for many to be able to get into the investment.

2.) The Black Box: Since they aren’t subject to as much regulatory standards, there isn’t a lot of transparency with hedge funds. So it’s typically unlikely to know exactly where and how the fund is investing and you might get performance figures just once a month. And there are the liquidity issues. Typically your investment will be restricted from withdrawal for a certain period of time and after that you may be only able to liquidate periodically such as quarterly.

3.) Biased Performance Figures for the Industry: The hedge fund world as a group has displayed superior returns over the past decade. But the data can mislead. First is “backfill bias”. This is when hedge funds begin reporting their performance and include their prior performance. And it’s likely when they volunteer that information, it’s because they had good prior returns. Poor performing funds will be reluctant to display this. Then there is what’s called “survivorship bias”. Funds that fail and go out of business are dropped from reporting databases and not reflected in industry performance figures. According to a study by Roger Ibbotson and Peng Chen, they indicated that prior to taking these factors into account, the TASS database of hedge funds returned 16.5% a year between year end of 1994 and April 2006, outpacing the S&P 500’s return of 11.6%. After taking these bias factors into account, the TASS database would have returned 9%.

4.) Costs: Many hedge funds have high management fees. Typically hedge funds charge what is called “one and twenty” which is 1% annually and 20% of the profits. This can be a very sizable sum over time. And this doesn’t include trading, administrative, and tax costs which can be all quite substantial depending on the strategy the hedge fund employs. Hedge fund of funds have even higher fees, these can run in excess of 5% annually.

I’m not an advocate of using private hedge funds. The black box nature of these funds doesn’t fit my level of comfort. And even though most hedge funds are legitimate and are looking to maximize investor wealth, Bayou Management fooled an awful lot of smart people. And other firms such as Amaranth Advisors show that there can be quite a bit of risk in these vehicles depending on what you choose. Just like a car, I like to look under the hood when I purchase it and periodically when I drive it. And decide to not to buy or sell it at will if I don’t like what I see.

Even though I don’t believe that private hedge funds make sense for most investors, I believe that they should part of a well diversified portfolio. How so? Over the years, many mutual funds have become available that provide hedging strategies and Morningstar has even created a separate category called Long-Short to distinguish these funds. Some use a combination of strategies in an “all in one” approach. Other funds have become available that Morningstar categorized as Bear Market funds that provide a hedge against a specific risk such as negative fluctuations in the dollar, energy, market indexes, or even interest rates. So you can get your hedge fund exposure in a one fund format or create your own with a combination of funds. And you can do this with the transparency, liquidity, no wealth restrictions and for an initial investment as small as $1,000.

But the bottom line is that you should not expect hedge funds in any shape or form to beat the market. These strategies do carry higher than average costs; that alone will drag down performance. The value that using hedging strategies provide is that they can provide returns which can be better than bonds and add a higher level of diversification at the same time. Or in other words, layering hedge strategies within an atypical stock/bond strategy can actually enhance growth while mitigating downside risk. Look before you leap, but you can do it effectively if you do your homework.