Funds vs Separate Accounts Mutual Funds vs. Separate Accounts—The Tax Efficiency Debate As money managers who primarily use mutual funds to implement our investment strategy, we are often asked by current and prospective clients to comment on the tax efficiency of using mutual funds vs. separate account managers. Reading through the marketing materials promoting the use of separate accounts would lead you to believe that separate account managers are much more tax-efficient than mutual funds. We disagree.While mutual funds may be slightly less tax efficient than separate accounts when it comes to controlling the timing of taxable distributions, we believe this distinction will become increasingly less significant going forward, since we will in all likelihood be in a much lower return environment and many funds have greater capital loss carry forwards they can use to offset gains. Also, the "control" over capital gain income recognition that managers who use separate accounts claim to offer has recently been brought into question. As reported in Investment News, a study conducted by the consulting firm Cerulli Associates states, "Only about 30% of taxable separate accounts receive specialized tax treatment. The findings, part of a larger study of the profitability of that fast-growing segment of the asset management industry, challenge a pillar of separate-account marketing strategy."So, what are the facts about the tax efficiency of mutual funds and separate accounts? We believe that mutual funds and separate accounts both offer some tax advantages that are unique to their structure. The net differences are very small and often depend on the aggressiveness of the account manager in seeking to offset an investor's realized gains on a year-by-year basis by harvesting unrealized loss positions. For the ever-increasing number of clients who are paying the AMT or do not have sufficient miscellaneous itemized deductions to deduct their separate account management fees in full, there might be a net advantage to using mutual funds due to the deductibility of the fund's management fees.* In our money management business, even though we have access to some top-tier separate account managers, we have elected to continue to use mutual funds to implement a majority of our investment strategy. Funds provide us with access to some of the most well regarded money managers in the country in a format that allows us to easily trade in and out of our positions. In the end, we believe the best predictor of after-tax performance is strong pre-tax performance and that most management organizations assign their best management talent to vehicles that have attracted the most assets (i.e. mutual funds).*Mutual funds have a large built-in tax advantage in that mutual fund management fees are typically fully deductible against ordinary income. The fees for separate account managers may be tax deductible, but only if the investor is not subject to the alternative minimum tax AND if the investor has sufficient other miscellaneous itemized deductions to allow for the management fees to be deductible as an itemized deduction. The tax deductibility of management fees can be as much as a 45 basis point annual advantage to using mutual funds.A detailed analysis of the various issues relating to the tax efficiency of mutual funds vs. separate accounts is provided below: 1. Question: Are fees paid to the fund/separate account manager tax deductible?Advantage: Mutual FundsMutual FundsYes. Fund management fees are deducted from the fund's investment income (i.e. dividends, interest and under certain circumstances short-term capital gains). This treatment is the equivalent of an investor receiving an "above-the-line" tax deduction for the management fees. An individual in the 45% combined federal and state tax bracket investing in a fund charging 1% would pay a 1% gross fee and a 0.55% after-tax fee. * (1.00% less 0.45% tax benefit). *Assuming that there is sufficient net investment income (dividend income, interest income and short-work term capital gains) within the fund to allow for the netting of the investment management fee. Separate AccountsIt depends. Separate account management fees are characterized as miscellaneous itemized deductions. These fees are deductible if the individual's total miscellaneous itemized deductions (category includes investment management fees, tax return preparation fees and a few other items) exceed 2% of the taxpayer's adjusted gross income ("AGI"). High-income taxpayers may not be able to deduct these fees either because of the 2% AGI limit or because they are subject to the Alternative Minimum Tax. (Miscellaneous itemized deductions cannot be used to reduce an individual's alternative minimum tax liability.) An individual with a combined ordinary marginal tax rate of 45%, who pays a separate account manager a 1% fee, would pay an after-tax fee somewhere between 0.55% (if the expenses are fully deductible) and 1% (if the expenses are not deductible). 2. Question: Is there a possibility that an individual will recognize phantom income? Phantom income occurs when an investor receives a taxable distribution that was earned by another investor. For example, a mutual fund may have built-in gains from prior years. A new investor may receive a capital gain distribution from the sale of stock that had accrued gains prior to his or her investment in the fund.Advantage: Separate AccountsSeparate Accounts No. Separate accounts do not generate phantom income. This is an advantage of separate accounts since the taxable income that you recognize is limited to the income that you have earned.Mutual FundsYes. Individuals who invest in funds that have built-in capital gains may receive distributions of capital gains or dividends that they did not earn. This is often listed as a major disadvantage of investing in mutual funds. In fact, this disadvantage is often overblown. Investment managers who use funds can utilize a number of techniques to partially or fully offset phantom income distributions. For example, advisors can avoid investing in funds that have announced an anticipated capital gain distribution. Most fund companies post estimates of their anticipated year-end distributions in the fall. Individuals who plan to invest in a fund with an expected taxable distribution have a few options to reduce their taxable income:They can defer their investment until after the fund has made its year-end distribution. They can make the investment prior to the distribution date and sell off a portion of the fund to offset the taxable income distribution. (Note: a fund's value decreases by the amount of the taxable distribution, so the taxable income from a fund distribution can usually be offset by selling the fund and recognizing a taxable loss.) They can sell other positions in their portfolio with built-in losses to offset the capital gain distributions. Ultimately, phantom income is a manageable issue and does not represent a significant drag on after-tax returns for most funds. 3. Question: Can investors benefit from phantom losses? Phantom losses are the opposite of phantom income. Phantom losses occur when an investor receives credit for unrealized or realized losses that were incurred by a fund prior to the investor purchasing the fund. For example, a fund may have realized losses that have been carried forward into the current year.Advantage: Mutual FundsMutual FundsYes, mutual funds can benefit from phantom losses. For example, due to losses incurred in 2000 and 2001 many equity funds carried forward losses into the 2002 tax year. This is the case with several of the funds that we are using in our money management practice. These losses can be used to offset gains incurred in 2002 and later years. Individuals who invest in a fund with carryover losses during 2002 are able to shelter some of their taxable income with losses incurred by other fund shareholders.Separate AccountsSeparate account managers are not able to take advantage of phantom losses. The income or losses that are earned by each separate account client only accrue to that account holder. 4. Question: Can an investor control the amount of capital gains recognized by the manager?Advantage: Possibly Separate AccountsSeparate AccountsReams of marketing materials tout the advantage of using separate account managers instead of mutual funds due to their greater tax efficiency. Though separate accounts do offer more flexibility regarding when capital gains are realized, there is little statistical evidence to suggest that these accounts offer better after-tax returns. In fact, a study conducted by the consulting firm Cerulli Associates that was quoted in the Investment News states that "only about 30% of taxable separate accounts receive specialized tax treatment. The findings, part of a larger study of the profitability of that fast-growing segment of the asset management industry, challenge a pillar of separate-account marketing strategy."Mutual FundsMutual fund shareholders cannot control the amount of capital gain income recognized by the mutual fund's manager. That being said, there are a number of ways to reduce or eliminate the capital gains distributed by a mutual fund.After making a taxable distribution, funds often sell at a loss (for tax purposes) since the distribution reduces the fund's NAV share price dollar-for-dollar. If the fund was recently purchased, the fund can typically be sold to offset some or all of the gains. If an individual owns a diversified portfolio of funds, typically they can sell off some of their other fund holdings that have built-in losses to offset capital gain distributions. Something else to note is that equity returns will likely be much lower than the double-digit returns we have witnessed throughout the 1990s. This lower return environment will naturally decrease the amount of taxable distributions from equity funds. The lower return environment will also create a more competitive environment for fund managers, and increased attention to tax efficiency will be required as managers are looking for ways to add value. 5. Question: Can the relationship manager sell funds/securities to offset realized capital gains?Advantage: TieMutual FundsYes, the advisor can sell fund positions to offset realized capital gains. Over time this becomes more difficult as fewer and fewer funds have built-in unrealized losses. In fact, the more tax efficient an account has been in the early years, the more difficult it is to find loss positions to offset future gains.Separate AccountsYes, the advisor can sell stock positions to offset gains. Over time this becomes more difficult as fewer and fewer stocks have built-in unrealized losses. In fact, the more tax efficient an account has been in the early years, the more difficult it is to find loss positions to offset gains. 6. Question: Are the after-tax returns competitive using this approach?Advantage: TieMutual FundsThe after-tax returns earned by a client will typically depend on four factors:The skill of the advisor in devising an asset allocation strategy. The amount of tax loss "harvesting" (i.e. selling fund positions with unrealized losses to offset gains) that is completed during the course of the year. Some loss "harvesting" trades may be executed within the fund. Tax loss "harvesting" trades may also be executed by the advisor (by selling fund shares). The skill of the advisor in selecting fund managers that deliver strong after-tax returns. Whether or not the fund's fee is tax deductible. Separate AccountsThe after-tax returns earned by a client will typically depend on three factors:The skill of the advisor in devising an asset allocation strategy. The amount of tax loss "harvesting" (i.e. selling stock positions with unrealized losses to offset gains) that is completed during the course of the year. Some tax loss "harvesting" trades may be directed by the advisor and some may be directed by the separate account manager. The skill of the advisor in selecting separate account managers who deliver strong after-tax returns. Whether or not the separate account manager's fee is tax deductible. 7. Question: Is there a problem with unrealized gain "hand cuffs" that force an advisor to maintain a position that is no longer recommended by the advisor?Advantage: Mutual FundsMutual FundsYes, if an advisor holds a position in a fund for several years it may become difficult to sell the position because of its large built-in gain. Since mutual funds often own 25-75 stock fund positions within the fund, the risk of holding a large fund position is much lower than owing a similar sized position in a single stock. Separate AccountsYes, if an advisor holds a position in a stock for several years, it may become difficult to sell the position because of its large built-in gain. This could present a problem when an individual owns large positions in a few companies in the same market sector. This was a problem with many U.S. growth stock money managers who, by early 2000, owned a large percentage of technology stocks in their portfolios with large built-in gains. Many managers did not want to recognize gains so they held onto large technology stock positions that plummeted in value. 8. Question: Can short-term capital gains be used to offset long-term or short-term capital losses generated outside of the managed portfolio?Advantage: Separate AccountsSeparate AccountsYes, net short-term capital gains can be used to offset long-term or short-term capital losses generated outside of the separate account manager's portfolio. Mutual FundsIn a strange quirk of mutual fund accounting, net short-term capital gains (short-term capital gains in excess of long-term and short-term capital losses) are treated as ordinary income distributions. Therefore, taxpayers cannot use net short-term gains earned within a fund to offset capital losses realized outside of the fund.