Injury, Meet Insult

Back in the day, investors looking to realize gold-plated dreams on Wall Street spent hours poring through newspapers and magazines to sniff out promising stocks. By the 1980s, though, many investors grew tired of picking their own and turned management over to mutual funds. Peter Lynch became the iconic celebrity manager after first joining the company as an intern (after caddying for Fidelity executives). Today, the Investment Company Institute reports that Americans have $25 trillion socked away in funds, and there are actually more funds than individual stocks listed on the three major stock exchanges.

But mutual funds have an expensive Achilles heel for investors who don’t feel like sharing their gains with Uncle Sam. A recent lawsuit shines a light on just how badly their pooled structure hurts you. It turns out mutual funds are the only investment where you can lose money and wind up still paying taxes!

Let’s say the XYZ Growth Fund bought stock in a buzzy startup called Microsplat in 2016 when it was trading at just $20/share. In 2020, the fund made Money Magazine’s "10 Hot Funds to Buy Right Now" list. You picked up a copy at your dentist’s office, thought XYZ Growth looked good and bought in when Microsplat was trading at $80. But for some reason, the Robinhood crowd soured on Microsplat, and the price started to fall. XYZ’s managers decided to dump their holdings at $60/share.

That’s still a nice gain for the fund. The managers patted themselves on the back and headed out for a steak dinner on your dime. But you lost 25% of your stake (the difference between the $80 that Microsplat was trading at when you bought into the fund and the $60 when managers sold). What’s even worse, at the end of the year, XYZ will report $40 of capital gains for each share, then send you a 1099-DIV reporting your share of that gain. Even though you didn’t profit from it before you invested. Even though you lost money on the trade! Suddenly diving into the pool isn’t so much fun, is it? (You remember back at summer camp, that one kid nobody liked? Remember what he did in the pool?)

These sorts of distributions are especially common in choppy or falling markets, when investors spook and dump their fund shares, forcing managers to sell stocks to raise cash to pay redemptions.

Now CNBC reports that three investors have sued Vanguard Group for setting off just such a stampede. The plaintiffs held shares in Vanguard’s target-date retirement funds, or TDFs. Vanguard offers two classes of TDFs: an institutional class with a $100 million minimum and a retail class with smaller minimums but higher fees. But back in 2020, Vanguard lowered the minimum on the institutional class to just $5 million. That prompted investors who could meet the new minimum to flee the retail class for the lower-fee institutional class. And that, in turn, forced Vanguard to sell 15% of the retail fund’s holdings to cash them out, unlocking millions of dollars in gains – and triggering millions in taxes. Now those plaintiffs are arguing Vanguard’s decision violated their fiduciary responsibility to their investors.

Separately managed accounts may be one alternative, especially in taxable accounts. SMAs let you hire a manager to assemble a portfolio of individual stocks from the ground up. There are no embedded capital gains like there are in mutual funds. You’ll enjoy more control and transparency over your portfolio than with funds and more flexibility to sell or make charitable gifts of individual securities.

Here's your bottom line: Taxes don’t just happen. Your investment choices play a big role in your overall tax bill. So call us at (562) 281-1040 to help you understand the tax consequences and let us help you make smart choices!