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3 Ways Your Financial Advisor Spots a Mutual Fund Hoax

January 10, 2021

There are two types of mutual fund capital gains – short-term and long-term. Simply stated, if a mutual fund (not the mutual fund investor), has held a stock for more than one year, then the profit from a sale is treated as a long-term capital gain, which is subject to a maximum of 20% tax rate for mutual fund shareholders. On the other hand, if the mutual fund has held a stock for less than one year, then the profit from the sale is treated as a short-term capital gain and is taxed at the fund investor’s ordinary income tax rate.

Early in the fall, mutual fund firms begin publishing estimates of their capital gain distributions and then make final distributions before the end of the year. But mutual funds don’t all make distributions on the same day – they just need to do so before December 31st. And to help you keep track of the distributions and whether they are short- or long-term, mutual funds report this information to shareholders on IRS Form 1099-Div after the end of every year.

2020 Cap Gains Could Set Records

By many estimates, mutual fund investors will likely see a record year for taxable distributions tied to capital gains in 2020. While we will not of course know precisely how much will be distributed this year until 2021, history can provide us an idea.

According to data from the Investment Company Institute, mutual funds paid out total capital gains of $511 billion and $355 billion in 2018 and 2019, respectively. Why was 2018 so much greater than 2019?

Well, part of the reason was that in 2018, investors saw a lot of volatility. Further, there was a lot of selling pressure on mutual funds, especially towards the end of the year. Remember that the S&P 500 ended 2018 down 4.38% and during the months of October and December of that year, the S&P 500 lost 6.84% and 9.03%, respectively? Those declines placed a lot of selling pressures on mutual funds.

Two More Reasons Cap Gains Will Be High

But 2020 brings two unique influences that will further shape the extent of capital gains paid out this year.

The first is obvious: COVID. Investors clearly remember the record market highs from earlier in 2020, followed by a couple of market corrections, a legitimate bear market and a staggering market recovery that has pushed U.S. stock markets to new highs. And along the way, there was lots of volatility and lots of buying and selling by mutual fund portfolio managers.

But it’s the second influence that doesn’t get talked about too often, but it happens every year and 2020 might be more severe: “window-dressing” by mutual fund portfolio managers.

Window-Dressing Mutual Funds

Every mutual fund must list their actual holdings four times a year at the end of every quarter and most fund companies send investors copies of these reports (or they can be found online too). But what you might not know is that the list of fund holdings is only a snapshot on one particular day – not all the actual holdings that were owned throughout the quarter.

Knowing this, some portfolio managers will sell certain stocks and buy others right before the time that their holdings will be reported – thereby presenting a better picture – the window-dressing – to shareholders. And while this practice can occur at the end of every quarter, it is much more common at the end of the year, when investors are more apt to pay attention to their mutual fund holdings.

In an interview with the Wall Street Journal, Russ Kinnel, from mutual fund researcher Morningstar, had this to say about mutual fund window-dressing:

“The basic concept is that managers are either hiding their mistakes or adding winners to make themselves look a little smarter.”

Window-Dressing is Easy to Do

Let’s say you own the Big Country Large Cap Stock
Fund and it returned 12% for the year vs. the S&P 500, which returned 18%. The Big Country LCS Fund also bought stocks A, B and C at the beginning of the year and unfortunately, they each had negative returns for the year, thereby dragging down the overall performance of the Big Country LCS Fund.

Unfortunately, the Big Country LCS Fund did not own stocks D, E and F, which is too bad because each of them enjoyed widely publicized, double-digit returns for the year. So, in an effort to fool investors and make it appear as if the Big Country LCS Fund had invested in stocks D, E and F the whole time, the portfolio manager sells stocks A, B and C and replaces them with stocks D, E and F two days before the year is over.

Shareholders get their Annual Report and only see that their beloved Big Country LCS Fund “owns” stocks D, E and F – they don’t see that it really owned stocks A, B and C for most of the year. The Big Country LCS Fund was window-dressed.

How Your Advisor Spots Window-Dressing

While window-dressing isn’t illegal, it is more than disingenuous. So, how does your financial advisor determine whether a mutual fund was window-dressed? Here are 3 things your advisor looks for:

  1. Your advisor analyzes a mutual fund’s overall performance, net of fees, compared to an appropriate benchmark. So, how did the Big Country LCS Fund compare to the S&P 500? Because anyone can move holdings around until they are blue in the face – but you can’t hide bad performance.
  2. Out-Of-Place Holdings. Your advisor reviews the holdings in your mutual funds to determine if something seems out of place. For example, based on its name, you can surmise that the Big Country Large Cap Stock Fund owns large cap stocks, right? If your advisor sees a bunch of small cap stocks in its Top 10 Holdings, then something is amiss.
  3. High Portfolio Turnover. Portfolio turnover is exactly what it sounds like – how often a portfolio manager is buying and selling stocks within a mutual fund. If a mutual fund owns 100 stocks and sells 10 of them during the year, then the fund’s portfolio turnover is 10%. Now, higher portfolio turnover is not necessarily bad (although it will increase trading costs and expenses), but higher turnover does point to more buying and selling and your financial advisor will find out why. Is it part of a strategy? Or is it window-dressing?

Your financial advisor examines your mutual funds with great frequency to understand 1) how they performed and 2) why they performed.  And mutual fund window dressing is just what it sounds like and it is designed to fool you.

But your financial advisor will not be fooled.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

This article was prepared by FMeX

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