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A Little Background


Mutual funds have steadily grown over the decades to become an industry behemoth with many trillions of dollars of invested assets. Conversely, only in recent years has the once somewhat exclusive investment advisory business begun to broaden its appeal to more and more investors. Also, in recent years emerging technologies have opened the door to efficient actively managed professional investment advisory services for virtually any account size. These and other factors have contributed to the increasing popularity of investment advisory services for many investors. However, through mass marketing and mere familiarity, the vast majority of investors continue to gravitate toward mutual funds and are unaware of the potential advantages of an investment advisory solution.


We believe an investment advisory account has many advantages over that of a traditional mutual fund. The first of which involves the concept of Total Cost of Ownership or what we will refer to as “Price” but there are also two additional key areas of consideration, Protection and Performance. When carefully evaluated, we believe these three general categories provide a sound basis for every investor to consider “repositioning their mutual fund assets” to an investment advisory account.


Three Reasons To Reposition Mutual Fund Assets


Reason 1: Price. 


Every investment vehicle has some type of fee or cost associated with it and this of course applies to both mutual funds and investment advisory accounts. However, few people realize the total cost associated with a mutual fund and most believe the only cost is the expense ratio which is disclosed by regulation in every mutual fund prospectus. However, mutual funds also have what is referred to as “hidden costs”. These are expenses related to various activities of the fund that are NOT required to be disclosed by the prospectus, yet these expenses definitely contribute to the cost of any mutual fund.


These so called “hidden costs” are considered as embedded expenses that reduce the reported performance of the mutual fund. To illustrate, assume the actual appreciated value of the assets of a fund is 8% and the fund has a disclosed expense ratio of 1% and an undisclosed hidden cost for trading of 1%. In this example the reported performance of the fund would be 6% (8% - (1% + 1%)). In this case the investor normally has no idea the value of the fund actually increased by 8%, they simply know their fund grew or appreciated by a reported rate of 6%. This in no way is intended to imply that fees in and of themselves are bad. If that were the case, then the only solution would be NO fees which of course would mean no value-added services for any investment. But it does mean that fees

should be considered and more importantly as we have discussed previously, the Total Cost of Ownership or TCO of an investment must be understood or considered as opposed to simply evaluating disclosed fees.  


So, how can someone determine the real cost of their investment, especially a mutual fund. Unfortunately, that can be nearly impossible because a mutual fund prospectus is only required to disclose its specifically calculated expense ratio. However, a study by the Financial Analyst Journal authored by finance professors at the University of California Davis, University of Virginia and Virginia Tech indicated that in addition to the disclosed expense ratio, which averages 1.19%, virtually all mutual funds have numerous types of so-called hidden fees. These include such things as inefficient tax processing, attempts to improve performance reporting through a practice called “window dressing” and the actual cost of buying and selling the holdings of a fund. 


While the actual fees themselves and the amount of such fees can be quite different from one fund to another, it is still important to realize that these fees can have a significant impact on the total cost of an average mutual. But again, it can be virtually impossible to quantify the actual cost for any specific fund.  However, it may be helpful to at least understand the average cost of the one “hidden fee” fee that is required for all mutual funds, the management of assets by buying and selling various securities. While this activity can vary widely from fund to fund, the study did calculate that the average estimated cost for buying and selling securities or the trading costs for the average mutual fund was 1.44%. That means that based on this study, assuming the average cost for the disclosed expense ratio and the average cost for trading, the average mutual fund has a total cost of 2.63%. And when considering other hidden costs, the study determined that the total cost of an average mutual fund is well in excess of 3.00%.


Conversely, an investment advisory account by regulation must disclose all applicable investment advisory fees and it is very easy to determine the cost of the underlying holdings of an investment portfolio. Therefore, a well-constructed investment advisory account that uses low cost underlying holdings, such as exchange traded funds or individual securities, may well have a total cost that not only compares favorably to a mutual fund but may often be significantly lower. This lower cost can have a significant impact on the value of an account.


Regarding the Total Cost of Ownership a cost variance of just 1% for two similar investment programs can have a significant impact on account values. Even if the cost variance is much lower, the other advantages of an investment advisory account may likely result in a significant increase in value over a mutual fund.


Reason 2: Protection. 


Protection is a term that is normally used with various forms of insurance but as it applies to investments, protection against significant loss can have a significant impact on the value of an investment. Most mutual funds seldom discuss or refer to this matter. One reason is that the average mutual fund MUST remain invested in its designated investment asset class and employs what is often referred to as a “buy and hold” strategy. This means the mutual fund will generally track the performance of its designated asset class or benchmark and will participate in any upside performance but is also exposed to inevitable downside performance. Most mutual funds concentrate or focus on their ability to outperform a particular benchmark on the upside, but few even attempt or have the capability to implement strategies to protect assets during periods of negative performance. This inability to provide asset protection can be hard to overcome and can therefore have a significant negative impact on long term performance. This is especially true if a client is in the distribution phase of their investment cycle. The need to receive income by distributing assets during periods of negative investment performance can have a double negative impact on account value and potentially jeopardize future income distributions.  


On the other hand, an investment advisory account, especially one that implements a tactical realignment of multiple assets classes to include cash in periods of extreme volatility, has the capability to focus not only on asset appreciation but also asset preservation or protection. As the chart below illustrates one reason protection against downside performance is so important is that the amount of positive performance required to offset or recoup a loss is significantly higher than the amount of the negative loss itself.




















Reason 3: Performance. 

Of course, the ultimate goal of any investment is to achieve acceptable performance. Yet, everyone knows that the desire for performance must be tempered or balanced by the reality of the risk associated with the possible loss in value. An unbridled focus on performance more often results in ultimate periods of inevitable losses. So then, how can an investor properly balance these two conflicting forces. Well, with any investment the first step is to determine a general risk tolerance and then craft a portfolio with investments that are somewhat consistent with that risk tolerance. But additionally there are other things that can be done to mitigate or somewhat control the performance versus risk conundrum. We have already touched on two that can improve overall performance, a proper understanding of fees and where possible avoidance of significant losses. Which brings us to what we feel is the third advantage of an investment advisory account over that of a traditional mutual fund.


As we have already alluded to, the average mutual fund by nature of its regulatory structure generally promotes a buy and hold approach to investing. Which purports that staying fully invested is the preferred course because by doing so you are assured of capturing all available upside performance. The mutual fund industry generally supports this position by providing illustrations which demonstrate the obvious disadvantage of missing any days of positive performance. But few if any mutual funds point out the distinct advantage of avoiding periods of significant loss. In other words, which contributes more to long term performance? The capture of positive performance or the avoidance of losses during periods of negative performance. The following chart provides some interesting information.











What About Taxes?


We believe there are sound reasons to transition mutual fund assets to an investment advisory account and this applies even after the consideration of the effect of taxes. Yes, no doubt the repositioning of assets from one investment to another investment could and in many cases will result in a taxable event. But first of all, it must be noted that the consideration of taxes does not apply to the proper transfer of one qualified account to another qualified account. And even if taxes were involved with a non-qualified account, it is our opinion that an immediate relatively minor tax decision should never outweigh a long term highly significant investment decision.  To illustrate, let’s assume an original non-qualified investment of $100,000 had appreciated to $120,000. The transfer of such assets would result in a long-term capital gains tax liability of $3,000 ($20,000 X 15%). But let’s assume a 2% improved performance variance with the new investment that averages a 7% annual return. Note the significant improvement in value in the chart below.

The following chart is for illustration purposes only and does not reflect the performance that an individual investor may experience.












We do not intend to provide tax advice and we encourage a client to consult with a tax professional for any individually specific situation. But in our opinion, one should carefully consider the many advantages of repositioning mutual fund assets even if a potential immediate tax liability may occur. Also, consider that any payment of current taxes will have the effect of increasing the cost basis of the new investment thus further reducing future tax liabilities. This matter of taxes also brings up another potential disadvantage of a mutual fund. Buys and sells of holdings within a mutual fund can and often do create tax liabilities, even in a year when no distributions from the account were processed and the fund may have actually lost value. Again, adding yet another reason that an investment advisory account has the potential to deliver overall improved investment results.  




So, in summary we believe every traditional mutual fund investor will likely be better served by taking advantage of an investment advisory account for four key reasons, Cost, Protection, Performance. And even after considering potential tax liabilities, an investment advisory account provides the opportunity for a superior investment program. We advise every mutual fund investor to consult with an investment advisor representative and at least evaluate and consider the potential advantages of repositioning their mutual fund assets to a professionally managed investment advisory program. 



This material is for general information only and is not intended to provide specific advice or recommendations for any individual. 

There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. 

Investing involves risks including possible loss of principal. Any illustrations do not intend to imply the actual performance that may be experienced by any individual investor. Past performance is no guarantee of future performance.

The Potential Advantages Of Repositioning Mutual Fund Assets
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