Motley Fool Answers: Mutual Fund Facts

Mutual funds may not be as sexy as buying individual stocks, but they can be an important part of your portfolio.

On this episode of Motley Fool Answers, Alison Southwick and Robert Brokamp dive headlong into talking about mutual funds. In addition, the two have fun with another not-so-obviously enjoyable topic: tax-managed funds. They also answer a question about capital gains taxes and dividends.

To bring it all home, Bro shares five facts about mutual funds. Some will surprise you, and others may help you make good decisions.

You'll even learn what a Boglehead is and share in a few other surprises from the Answers team.

A transcript follows the video.

This podcast was recorded on Oct. 4, 2016.

Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick, and I am joined, as always, by Robert Brokamp, personal-finance expert here at The Motley Fool. Robert, how are you feeling today?

Robert Brokamp: Oh, I'm feeling just great, Alison. How are you?

Southwick: Oh, I'm feeling good, too. Today we are going to take a closer look at mutual funds. Chances are some of your money is sitting in one right now, but what's it doing? Robert Brokamp is going to help us take a peek. We're also going to answer your questions about tax-managed funds. That doesn't sound very interesting at all, but we'll see. And meet some unreasonable people who made history. All that, and more, on this week's episode of Motley Fool Answers.

Seriously, like, tax-managed funds? Argh.

It's time for "Answers, Answers." Barry writes: "Hi, Fools. My broker is recommending I get into a tax-managed fund. I certainly understand the idea of favoring capital gains over dividends to decrease current taxes." Oh, I need to unpack that sentence here. I currently understand the idea of favoring capital gains over dividends to decrease current taxes.

Brokamp: Right, because you pay taxes on your dividends each and every year, but [with] capital gains you can defer them...

Southwick: Oh, until you sell.

Brokamp: ...until you sell. There you go.

Southwick: "...but I'm not clear on how stocks might be swapped in these funds to maximize the tax advantage. Can you please explain how these funds work?" Yeah, explain how these funds work!

Brokamp: Well, Barry, it's a really good question. First of all, we're really talking about mutual funds that you hold outside of your IRA and 401(k). If you have it in those accounts, you don't have to worry about any of these tax consequences.

But there's a funky thing about the taxation of mutual funds, and that is even if you're holding onto the fund and you're not selling it, you are going to be held accountable for any capital gains that are generated when the manager buys and sells a fund inside the fund. So, let's say you hold a fund. It bought a stock three years ago for $50. It sells it today for $100. That's a $50 capital gain per share that has to be distributed to the owners of the fund.

The crazy thing about that is if you just bought the fund yesterday, you're still going to be liable for that $50 per share capital gain. These gains have to be distributed once a year. They tend to happen toward the end of the year, so if you're thinking of buying a fund in a taxable account, now may not be the best time of year to do it. You can call the fund company, tell them you want to buy this fund, and then ask them if it looks like they're going to make any capital gains distributions and they'll tell you. So if you have a fund that is outside of an IRA or a 401(k), it makes sense to look at the tax efficiency of the fund.

First of all, [tax-managed funds], as you point out, might favor stocks that don't pay dividends over ones that do. Or if they buy a stock that has a dividend, they want to make sure that it's a qualified dividend. Qualifying dividends are taxed at lower rates than regular dividends. That involves the type of company.

It also involves making sure that you hold onto that stock for a while. They might be more inclined to hold onto the stock longer. For capital gains, a short-term gain is one that you sell within a year, and you're going to pay a higher tax rate than if it's a long-term capital gain, so that manager is ideally going to hold onto the stock longer.

Just like individuals, mutual funds can do tax-loss harvesting, so they can do losses to offset the gains. A tax-managed fund will be more likely to do something like that. And also if the fund involves investments in any kinds of bonds, it might choose bonds that have tax breaks like municipals, Treasuries, things like that.

Now, one thing you should know, though, is that index funds and ETFs are already pretty tax efficient, and they have lower costs than the average tax-managed fund. You might want to ask your broker, "Is this really the best fund for me, or should I just get an index fund?"

And one way to determine the tax efficiency of a fund is to look it up on Morningstar. You'll see a little button there called Taxes. And they have something called a Tax Cost Ratio, which is basically an estimate of how much of your return is lost to taxes. Look at this tax-managed fund that the broker is recommending, compare it to a relevant index fund and see. Maybe an index fund would be a better bet for you.

Southwick: There you go, Barry. Your advisor says, "Go here," and you go back and you're like, "No!"

Brokamp: That's right.

Southwick: Because I went to Morningstar, I hit a button and boom!

Brokamp: I should be advising you!

Southwick: Yeah!

Brokamp: And then ask for a commission for that advice.

Southwick: We can get a kickback.

__

Southwick: Mutual funds are often described as a basket of stocks, which makes them sound quaint and cute like a basket of puppies, but they are nothing like a basket of puppies unless, of course, the puppies are wearing little suits and nine out of 10 spend the day eating your dollar bills. Today, Bro is going to share five not-always-fun facts about mutual funds so you can get the most out of those cute, wittle, fuzzy, wuzzy faces in your portfolio. I wish we were talking about a basket of puppies.

Brokamp: Yeah, yeah.

Southwick: Just to get on the same page, Bro, what is your elevator-ride explanation of a mutual fund, and you can't say basket of stocks.

Brokamp: A pooled investment where...

Southwick: Oh, that's worse...

Brokamp: ...hundreds, thousands, millions of people send in their money to a single mutual fund manager, or team of managers, and they decide how to invest that money. It could be stocks. It could be bonds. It could be a mix. It could be commodities. It could be real estate. There are all kinds of mutual funds, but it's basically a way to invest in all kinds of different securities very easily with the help of some professional management.

Southwick: All right. So without further ado, the first thing you maybe didn't, but probably should, know about mutual funds is that the costs are the most reliable indicator of future returns.

Brokamp: Right. And when you're in a situation where you're picking a fund — and a lot of people are, whether it's because they're looking for funds, or it's what you have as a choice in your 401(k) — you have to decide which fund you should choose. And most people look at the past returns, but actually most studies indicate that returns may not be the best indicator of what will happen in the future.

S&P does something called its Persistence Scorecard. They basically take a look at which funds outperformed over one period and then how many of them continued to outperform over the subsequent period. For example, from March, 2006 to 2011, of the top 25% of funds (the ones that were in the top quartile) what percentage do you think then remained at the top quartile from 2011 to 2016?

Southwick: Uh, five.

Brokamp: Well, no it's a little better than that, 17%.

Southwick: OK, sorry. I went too low.

Brokamp: You went too low, but that's still pretty remarkable.

Southwick: Yeah.

Brokamp: Thinking you've got a fund that performed in the top 25% over the past five years so surely this is going to be a winner. You had a less than one-in-five chance of that continuing.

However, when you look at costs (any study that breaks up the mutual fund universe based on costs), over and over again it shows that lower-cost funds tend to outperform higher-cost funds. These, of course, are the averages. There are many great funds that have performed over the long term and charge at least medium, if not even above-average costs. But on average, if you're looking to put the odds in your favor, go with a lower-cost fund.

Southwick: All right. The second thing that you maybe didn't know, but probably should, about mutual funds is that the expense ratio isn't the final word on what you're paying. It's just not that clear-cut, is it?

Brokamp: Right. And when we talk about costs with a mutual fund, that's the first place you look, is the expense ratio, and it's always expressed as a percentage. It's the percentage of assets that the fund company is going to take of your money to cover all the costs (the management, the administrative costs, recordkeeping, and things like that).

Southwick: Like if I give a mutual fund a hundred bucks, and its fee is 1%...

Brokamp: Right...

Southwick: ...then every year? Every quarter? I know you've told me this before.

Brokamp: Every day there's an end-of-the-day accounting for the costs and the value of all the investments in the fund, and then they do that accordingly.

Southwick: And then they just pull a few pennies away.

Brokamp: Exactly.

Southwick: OK.

Brokamp: Exactly. So that's the first place people look, but it actually doesn't account for all the costs. It doesn't account, for example, for the commissions that the fund manager pays to buy and sell the investments. It doesn't account for any commissions you paid to get into the fund — so a front-end load or a back-end load. That's generally if you're buying it from a financial advisor, but not always. Some funds do charge a front-end load...

Southwick: And a front-end load is like an initial, one-time 5% fee or something.

Brokamp: Exactly, 5%. Even Vanguard used to charge front-end loads on some of their funds — or on the back end — because they were trying to discourage people from being in there for the short term. They were trying to get people to pay if they were just holding it for the short term.

And then there are the taxes, which we talked about in the Answers, Answers segment. There are even some well-known money managers, fund managers, asset managers who in their taxable accounts know that they should just stick with index funds because the taxes that come from investing in actively managed funds can outweigh any benefits in many cases.

Southwick: Are 12B-1 fees still around?

Brokamp: Yes, and that is an ongoing marketing fee. When you think about it, you as a current fund shareholder are paying for the marketing costs to acquire...

Southwick: How weird!

Brokamp: ...new shareholders.

Southwick: That's so crazy.

Brokamp: It's kind of ridiculous. Not all of that is expressed purely in the expense ratio. To find out, for example, the commissions the manager is paying to buy and sell the stocks, bonds, or whatever is in the fund, you actually have to dig into their financial statement, so it's very difficult to find.

The closest thing to which you can approximate it is something they call the turnover rate, and that is each fund has a turnover expressed as a percentage. It's basically how much of the fund's investments have been bought and sold in the course of a year. Theoretically, if a fund had a turnover of 100% that means everything it had at the beginning of the year was gone at the end of the year. That will give you an idea of how much trading there is and how much in taxes might be generated.

Southwick: And the third thing you maybe didn't, but probably should, know about mutual funds is that most actively managed funds lose to index funds, particularly lately.

Brokamp: Right. I think a lot of people know that the majority of actively managed funds don't beat a relevant index fund. What they may not know is that the record is just getting worse. According to a Bloomberg article from a couple of weeks ago, only 9.5% of large-cap funds have beaten the S&P 500 over the previous five years. That's one of the worst records in history and it's the lowest percentage since 1999.

Southwick: Wow.

Brokamp: Now these things come and go — there are cycles — and if you were to talk to the active management industry, they would give you reasons like, "Well, it's a different kind of market. It's being juiced by the Fed, and by having these low interest rates." If you look back, for example, even as recently as 2009, the majority of large-cap funds beat the S&P 500. So it does go in cycles.

I think it's important to know that first of all, owning an index fund somewhere in your portfolio is going to be a winning strategy as part of your portfolio. No question about it. But, we are in unusual times, so if you have an actively managed fund that has a good long-term record, but that hasn't been looking so good over the past three years, you may not want to boot it just yet. You might want to give it a little more time.

Southwick: Which brings us to our fourth thing that you maybe didn't, but probably should, know about mutual funds and that is that active management does have its role.

Brokamp: Yeah. When you talk to people, there are people who are very hard-core index fund people.

Southwick: They're called Bogleheads.

Brokamp: They're called Bogleheads — named after Jack Bogle, the founder of Vanguard — and they're big fans of Vanguard. But the interesting thing about this is that Vanguard has always had actively managed funds, even when Jack Bogle was running the company, and Vanguard puts out reports saying you can have active (and what they would call passive or index funds) in your portfolio. You just make sure that you use the right criteria for choosing your active funds. I think it makes sense. I own index funds and actively managed funds.

Why would you own actively managed funds? First of all, there are some categories where active managers tend to fare better, such as emerging market stocks, and municipal and high-yield bonds. Costs are a big factor, as well. If you find a good, active manager but then you focus on costs (and that's what Vanguard does), you can show that you can do pretty well with these active managers. And the bottom line is there are funds that do beat their benchmarks over the long term, and it's not a bad idea to have some money in those types of funds.

Personally, I like to look for funds that do something a little different. It might be that they take a little less risk than the overall market. It might be that they have a wider mandate. So instead of saying it's a fund that is just large-cap value, it can go into midcap or small cap. One great long-term fund is Dodge & Cox Stock [Fund]. It's a US stock fund, but up to 20% of its assets can be in international stocks, so their managers can say, "We mostly focus on US stocks, but right now we're finding value in international stocks, so we can go there if we want." That has served is shareholders very well over the long term.

Southwick: And the fifth and final thing you maybe didn't, but probably should, know about mutual funds is that the types of funds you choose will have the biggest impact on your future wealth.

Brokamp: Right, and you may have read this or seen this somewhere. Basically the biggest determinant of how much money you're going to have in the future isn't which individual stock fund you buy, or even individual stock. It doesn't matter whether you get this Vanguard fund, or this Fidelity fund, as much as how much you have in stocks. How much you have in bonds. How much you have in international stocks versus US stocks.

Your asset allocation is ultimately the biggest determinant of how your portfolio is going to perform. So if you have a limited amount of time (you've got one hour on Saturday morning to figure out a way to improve your portfolio), don't spend it choosing the absolute best US large-cap value fund. Instead learn a little bit more about asset allocation and determine what the right mix is for you between stocks, bonds, and cash.

Southwick: Take us home, here. What's your Foolish bottom line about mutual funds?

Brokamp: First of all, I love mutual funds...

Southwick: Put that on a t-shirt!

Brokamp: I love...

Southwick: Some of my best friends are mutual funds.

Brokamp: They don't have "fun" in the word for nothing! The Motley Fool is known mostly for picking individual stocks, but most of my money is in mutual funds because I appreciate getting the diversification that comes from it, and I appreciate that in some cases I have the professional management of an active manager.

But there are certainly many criteria that you should be looking for to increase your chances of success. The low costs. The tax efficiency if it's outside of your IRA or 401(k). There's something that's becoming more popular, now, called active share and it has nothing to do with Sonny & Cher. It has to do with how much of an intimate...

Southwick: The duo was not making that mistake, but thank you.

Brokamp: It is how much of an individual fund's holdings differentiate or are different from the index. A lot of so-called actively managed funds are pretty much 95% of the index, and they'll never outperform. They're just like an index fund with higher costs, so they have this thing called active share. There's some research that indicates the more a fund is different from its benchmark, the higher chance it will have of outperforming. That research is being debated. There are other studies that have said maybe not. But it still makes sense, and if you were going to go with an actively managed fund, you want to look for something that is different from the index fund.

Southwick: Give you an edge, because otherwise why are you paying?

Brokamp: Exactly.

Southwick: So everybody go forth, do your research, find some good mutual funds. Maybe we'll have an episode coming up where you actually call out some of your favorite funds that you love so much.

Brokamp: I think that would be great. I look forward to it so much.

Southwick: I think that would be fun.

Brokamp: I'll get a t-shirt for each one.

Southwick: Yay!

__

Southwick: This week Elon Musk, Tesla and SpaceX founder, held a press conference to talk about how he intends to colonize Mars. Did you see this?

Brokamp: I did.

Southwick: He said that there will be a self-sustaining colony of 1 million people on Mars in the next 40 to 100 years.

Brokamp: Wow!

Southwick: Yeah, right? Wow! That's crazy. First off, I don't know why he would want to go to Mars.

Brokamp: I'm not sure I would want to be that person.

Southwick: But why does he even want to go to Mars? Like there's nothing there, but whatever. So headlines, following up his press conference, included ones like, "How Crazy is Elon Musk's Mission to Mars?"

In response to this, I saw a tweet that our CIO, Andy Cross, posted and it was a George Bernard Shaw quote. Basically the quote is, "All progress depends on the unreasonable man," and the full quote of this is, "The reasonable man adapts himself to the world: the unreasonable one persists in trying to adapt the world to himself. Therefore all progress depends on the unreasonable man."

Brokamp: It makes sense to me.

Southwick: I don't know. It got me thinking about how many investors, entrepreneurs, and scientists out there were completely dismissed, even though their research, and what they've created today is just like common sense. So today I just have one story. I want to introduce you to one guy.

Brokamp: All right, go right ahead.

Southwick: He was an unreasonable man that you've probably never heard of. His name was Dr. Ignaz Semmelweis. Does that sound familiar?

Brokamp: Absolutely not.

Southwick: The year is 1847, and he was in charge of a couple of maternity clinics. One was a teaching school, and that was staffed with physicians. The other one was a maternity clinic staffed with midwives, and it was meant for more low-income people. The funny thing was all of the rich people started wanting to go to the clinic meant for the poor people — the one with all the midwives. Do you know this story, Rick? It's a good one.

Semmelweis wondered what's up with that. It turns out that the wealthy people started noticing that if you went to the teaching school to have your child, you had a higher chance of dying in childbirth. In fact, it was three times higher than going to the midwife. Semmelweis dug into it a little bit, and he came up with this crazy idea that maybe doctors should wash their hands after messing with a cadaver before they then crossed the hallway to deliver a baby.

Brokamp: What a crazy idea!

Southwick: So of course all of the doctors of his time listened to him and immediately started washing their hands. No, no. Actually, Dr. Semmelweis was widely rejected. After all, it's an imbalance of the "four humors" that causes sickness, dummy.

Brokamp: The four humors.

Southwick: And some doctors were even offended that he suggest that as gentlemen they have unclean hands. How dare you, sir! What this mother needs is a good bloodletting. Sadly, Dr. Semmelweis fell into a deep depression after all of his colleagues widely dismissed him and mocked him, and he ultimately died in an insane asylum.

Brokamp: That's the sad thing about a lot of these people...

Southwick: Right?

Brokamp: They died before they knew the impact they had.

Southwick: Yeah! And so here's a list of some other people who were rejected for their audacious and unreasonable ideas — pretty much everyone, ever, who made a difference. Like that's my list. And it's no coincidence that Elon Musk's car company is called Tesla. I mean, talk about a genius guy who is considered unreasonable.

Brokamp: [Nikola] Tesla, we're talking about.

Southwick: [Nikola] Tesla. I think Elon Musk is absolutely unreasonable, too. I don't think that's a secret — that he is an unreasonable man — but even if you think as recently as Netflix, critics originally said, "Why would I wait two days for a movie to arrive in the mail when I can just drive to Blockbuster? That's crazy."

Brokamp: That is crazy.

Southwick: It is crazy.

Brokamp: I remember Mark Cuban criticizing Google's purchase of YouTube, saying, "Why would this site be worth anything? All it does is violate copyrights and give people a way to post their home movies. There's no future in it."

Southwick: Yes, but he didn't think about the power of cat videos.

Brokamp: That's true! That's true.

Southwick: Anyway, I have no takeaway. I just thought that as people like Elon Musk think about going to Mars, I'm like, "Ugh! Why bother?"

Brokamp: Well, here we are in the 40-year anniversary of the index fund, and certainly when John Bogle first came out with the index fund, he was roundly criticized and made fun of. And now look at him!

Southwick: Look at him now!

Brokamp: He's got eight figures, I think he said.

Southwick: He's got all the money.

Brokamp: He's got all the money.

Southwick: All the money. Well, not him personally, but all the money at Vanguard.

__

Southwick: Thanks to [Fellow Barshand] from Bville, Oklahoma, [Del Clarke] for the postcard, and also to Chaplain A.T. Tappman who yearns for us tragically from Maine. Hm. I thought he was a fictional character, but I guess I'm wrong. The show is edited reasonably by Rick Engdahl. Our email is [email protected]. Drop us a line. Go join our Facebook group. We have Motley Fool Podcasts — the Facebook group. We have fun.

Brokamp: We do. Lots of fun.

Southwick: Rick posts GIFs of...

Brokamp: What we actually do while we're doing it. We always tape these episodes.

Southwick: What we look like.

Brokamp: As someone on Twitter said, they were very surprised at what we look like, basically.

Southwick: Yeah, but then he circled back to say that he was more surprised about what you were doing in that GIF...

Brokamp: Yes.

Southwick: ...so if that's not enough to get you to go to Facebook to see exactly what Robert was doing, nothing will get you there.

Brokamp: You'll be disappointed.

Southwick: All right, that's the show. For Robert Brokamp, I'm Alison Southwick. Stay Foolish, everybody.