Did you know that according to Leichtman Research Group’s annual on-demand study, 54% of U.S. adults said they have Netflix in their household? Why do I mention this? Because it’s the same number of Americans that own individual stock, a stock mutual fund, or participate in a self-directed 401(k) or IRA, and roughly half those assets are outside IRAs. With the mutual fund industry at almost 19 trillion dollars, that’s a lot of capital in taxable accounts, where you may have ongoing fees and tax friction bringing your long-term returns down.

The expenses associated with acquiring and owning a mutual fund are not always as clear to the average person as buying a stock. To buy a stock, you simply give your broker an agreed-upon commission. Mutual funds, on the other hand, could also involve a commission as well, but since these are professionally managed funds, there are other expenses associated. Let’s go over a quick breakdown of those actual fees associated with owning a mutual fund. First, there are Sales loads. The broker’s commissions are usually charged either upon purchase, sale, or a level load. Front-end loads are the most basic type of load: Fees can be as high as 6% (side note, there is no load on mutual funds when buying in an RIA). Next comes the hiring costs. It’s also known as the management fee, this cost is usually between 0.5% and 2% of assets, on average. On top of that, there is what we call a 12b-1 fee. This expense goes toward paying brokerage commissions and toward marketing the funds. Incredibly, if you invest in a fund with a 12b-1 fee, you are paying for the fund to run commercials and sell itself! These fees cannot exceed 0.75% of a fund’s average net assets per year. Some other areas of concern with investing in mutual funds come from their annual trading costs which are, on average, higher than their expense ratio and negatively affect performance. They also have to spend money when an investor buys, and they have to sell investments when an investor sells.

Digging a little bit deeper, there are some glaring tax inefficiencies as well. When you purchase the mutual fund, you inherit the basis of each security owned by that fund at the time you purchase the fund unit. The ten most popular mutual funds by assets under management carried a 1.05% average annual tax cost over a five-year period. Looking at the top ten mutual funds by AUM as reported by Morningstar, the average turnover rate is 74.4%. This means these particular mutual funds turn over approximately 74.4% of their holdings during the year. Mutual funds are frequently forced to sell securities they own to meet withdrawals by fund shareholders. In fact, sales to meet investor outflows are often a leading cause of fund capital gains distributions. All this creates tax friction on the portfolio. Compounded over time, tax friction can have a serious impact on returns, eroding wealth for the investor. So, let’s actually put some numbers on what tax friction looks like in investors’ portfolios. On a million dollar portfolio, over 10 years, with 1% in annual tax friction, and with an 8% annual pretax return, the tax drag is more than 200,000 dollars.

Taking all this into consideration, what does it all mean? Over the last 15 years from 2002 to 2017, only 1 in 13 large-cap managers, only 1 in 19 mid-cap managers, and 1 in 23 small-cap managers were able to outperform their benchmark index. Over the one-year period, 63.08% of large-cap managers, 44.41% of mid-cap managers, and 47.70% of small-cap managers underperformed the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, respectively. Similarly, over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis. So, how can we bring down tax fiction, invest in the benchmarks, and keep fees low? How can we harvest tax losses while still being able to own individual sectors? Enter exchange-traded funds (ETF).

An ETF is a marketable security that tracks a stock index, a commodity, bonds, or a basket of assets. What are some of the benefits associated with ETFs? While there are more than 1,915 ETFs available today, more than 99% of the assets are invested in traditional index-based ETFs. Because most ETFs are passively managed, many ETFs carry very low expense ratios. The average ETF carries an expense ratio of 0.44%. Due to structural differences, mutual funds typically incur more capital gains taxes than ETFs. Moreover, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor. One area of concern with ETFs is that bid-ask spreads could be large. With a mutual fund, everyone that day gets the same price, at the close of the trading day; if an ETF is thinly traded, the price to buy versus the price to sell could have a large discrepancy. Costs could also run higher with ETFs then some mutual funds. With some index funds, you do not need to pay a commission, or fee to buy, with ETFs, they trade like stocks, and you get charged when you buy as a stock. So if you are dollar cost averaging in every week, you could be end up with a large amount of money given to commissions by the end of the year. Like stocks, the price of an ETF can sometimes be different from that ETF's underlying value. This can lead to situations in which an investor might actually pay a premium above and beyond the cost of the underlying stocks or commodities in an ETF portfolio just to buy that ETF. As you can see, there are many benefits to exchange-traded funds as opposed to mutual funds. A powerful tool for controlling taxable gains for the year is called tax loss harvesting. There are different types of tax loss harvesting, such as market volatility harvesting where you realize capital losses when the index level falls below cost, individual stock volatility tax harvesting, where you sell a stock below its cost basis, and tax lot harvesting, which occurs after you build up a portfolio, this allows you to sell based on when an individual tax lot goes below cost basis. Many investors don't realize that tax loss harvesting is an active measure, where most try to harvest losses at the end of the year, and it's usually reactionary, where an investor will call their advisor and ask for them. Whereas proactive tax harvesting can help keep overall tax friction down. 

How would you go about buying these products? You can go through a discount broker such as E*TRADE, Fidelity, or Schwab, and usually pay a low fee for under 10 dollars for ETFs. With mutual funds, most people go through either a broker or an investment advisor. In recent surveys, 76% of Americans don’t know the difference between a broker and an advisor, so let’s first define what each is, and the differences.

The U.S. Supreme Court has said that investment advisors are fiduciaries with “an affirmative duty of ‘utmost good faith and full and fair disclosure of all material fact, as well as an affirmative obligation ‘to employ reasonable care to avoid misleading’ clients.”(7) With brokers, they act in a suitability standard. Instead of having to place his or her interests below that of the client, the suitability standard only details that the broker-dealer has to reasonably believe that any recommendations made are suitable for clients, in terms of the client's financial needs, objectives, and unique circumstances. A key difference in terms of commitment is also important, in that a broker's responsibility is to the broker-dealer he or she works for, not the client. The suitability standard can end up causing conflicts between a broker-dealer and underlying client in a multitude of ways. The most glaring, of course, has to do with fees. Under a fiduciary standard, an investment advisor would be surely forbidden from buying a mutual fund or any other investment, for that matter, that would generate a higher commission. Under the suitability requirement, this isn't the case, because as long as the investment is suitable for the client, it can be purchased for the client. This can also incentivize brokers to sell products that generate more commission instead of products that may be at a lower cost. While it is possible to harvest tax losses in a brokerage account, the costs of trading individual tax lots, as well as rotating individual securities by paring them actively to gain a taxable advantage, start to outweigh the benefits.

The bottom line is, as we have seen with cost being one of the primary determinants of investment performance over the long term, the fiduciary standard seems to have the greater support in terms of affording a benefit for clients. Given the more rigorous requirements for investment fiduciaries, there is little question that the fiduciary standard better protects investors than the suitability standard. 

David J. Perrotto founded Perrotto Private Wealth in 2011, in New York City, with the goal of being a firm that controls its own destiny, one that remains independent from any bank, brokerage firm, or insurance company. With over a decade in the financial industry and with his own private practice, David has extensive experience with families, nonprofits, and small business owners, as well as their dependents in all areas of finance. David can be reached at Dave@Perrottowealth.com or (718) 551 – 7131.

Investments in securities do not offer a fix rate of return. Principal, yield, and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. No system or financial planning strategy can guarantee future results.

Exchange-traded funds and mutual funds are sold only by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus contains this and other important information about the investment company. Prospectus can be obtained by (718) 551–7131. Be sure to read prospectus carefully before deciding to invest.

Investment Advisory Services are offered through Bright Futures Wealth Management and/or Cetera Advisors LLC registered investment advisers. Securities are offered and sold through Cetera Advisors LLC, - a registered broker dealer. Bright Futures Wealth Management and Cetera Advisors LLC are not associated entities. Cetera is under separate ownership from any other company. Bright Futures Wealth Management is under separate ownership from any other company. Perrotto Private Wealth is under separate ownership.