Should I move funds from large bank with high fees even though there will be high gains?
I am extremely dissatisfied with the high fees on my mutual fund investments at a large bank. The investments are easily moved. If I decide to move them, I'm left with about $110k with $29k in capital gains. The expense rates are between .6% and .7%. I hate to leave any of them at this bank. Should I leave them there until some point in the future when I need the money? Or should I sell them, eat the taxes and take advantage of lower fees somewhere else for the next ten to 20 years?
Good question, and there are some great answers on here already. I would also suggest going to www.morningstar.com, type in the ticker in the Quote search bar, bring up the mutual fund, and click on the Expense tab. This tab provides some great information that includes comparing the expense ratio to its peers, but also a couple of other important factors. Check under the sales fees, and see if you have a deferred or redemption cost. Some funds may have a lower internal cost, but charge you to sell positions. Deferred costs go away after a period of time (often 90 days, but could be longer). Redemption fees will likely be charged when you sell the fund. Also look under the Other Fees/Expenses section. There is a line item called 12b-1 Actual, and this refers to fees going back to your advisor. It's a charge you don't see leave your account, but is paid as a commission trail out of your assets regardless.
I like the suggestion from a previous answer, where it was suggested you move the positions to a discount broker like Fidelity, Schwab or TD Ameritrade. They should be able to transfer the positions in kind, which means you wouldn't have to sell the positions and realize the tax liability. Then you can sell positions over time and spread out the impact to you. While we place a great emphasis on fees, it is more important to know whether the objective of the portfolio matches your objective and your risk tolerance. Some active managers can provide good value in helping control portfolio risk, but many U.S. equities are highly efficient already, and you will find limited value in active managers in domestic large cap or domestic mid cap funds. Often you're better in an ETF, but beware some ETFs are expensive as well. Look up their expense ratios in Morningstar as well.
Good luck to you!
I'd like to set this up as a math problem. The basic assumption I would like to make is that over very long periods of time, actively managed mutual funds with fees in the 0.6-0.7% range will correlate with the broader indexes but underperform them by the amount of the fee they take out each year. Yes, there will be periods of outperformance, as will be the case with anyone who is picking individual stocks--sometimes the coin comes up heads, sometimes tales. Over decades, though, the correlation of any stockpicker to the broader markets will be inevitable and the underperformance of actively managed mutual funds will likely be equal to the costs associated with churning an actively managed portfolio.
So you have $110k with $29k in embedded gains. Let's assume for now these are long term capital gains. If they are not, it is certainly worth waiting until the 366-day holding period elapses so you can get the preferential tax rate.
Let's assume that over the next 20 years, the total return on the overall market indexes is around 7% annualized. Obviously could be more, could be less. In 2017, the S&P 500 returned over 20% but it's not going to be that good every year. Let's assume the index funds and the actively managed mutual funds both perfectly track the overall market return and the only difference between their long-term performance is the fee being charged. You can buy index funds now with fees as low as 0.03%, versus the 0.65% in your mutual funds.
Annualized return of ultra-low-cost index funds after 20 years, net of fees: 6.97% (7% minus 0.03% expense)
Annualized return of actively managed mutual funds after 20 years, net of fees: 6.35% (7% minus 0.65% expense)
You have two options here. One is to sell the mutual funds now, take the tax hit, and then reinvest your after-tax proceeds in index funds at a compounding rate of 6.97% net. The other is to hold on to the mutual funds, pay no cap gains tax this year, and stay invested at an annualized rate of 6.35% net. Let's say you pay 15% in federal capital gains tax and 5% in state (not sure what state you file taxes in, could be more, could be less), so 20% total.
Option one: Incur $5,800 in tax (20% of $29k), leaving you with $104,200 to invest in ultra-low-cost index funds. $104,200 invested at 6.97% return over 20 years is 104,200 * 1.0697^20 = $400,966.
Option two: Stay pat, pay no tax. Your $110,000 investment compounds at 6.35% over 20 years, i.e. 110,000 * 1.0635^20 = $376,827.
It's pretty obvious in this example that you should go with option one. Liquidate those high cost funds and switch to the ultra-low-cost index funds.
There are three added cherries on top that make this decision even more of a no-brainer.
First, your cost basis in option one will be higher, $104,200 original cost with the index funds vs $81,000 cost with your mutual funds (the $110k investment you have today less the $29k embedded capital gains). This means when you eventually sell, you've already taken out $23,200 of cost basis that you won't have to pay tax on.
Second, all the academic data and literature I have ever read show pretty conclusively that actively managed mutual funds in fact underperform index funds over long periods of time--beyond just the extra fees. The above math example assumed perfect tracking of indexes, minus the higher fees. In reality, when you factor in other trading costs and adverse selection bias among mutual fund managers, actively managed mutual funds are amazingly bad in terms of underperforming the markets. Yes, you might get very lucky and you happen to be with a manager who rides the hot hand for a decade. But it's super unlikely, and even supposed geniuses have a bad year or two.
Third, the bank is likely taking an advisory fee on top of the mutual fund fees. For example, if the advisory fee is 1%, on top of the mutual fund fees of 0.65%, you are talking about a 20-year return of 5.35% after fees (7% market return, less 1% advisory fee, less 0.65% mutual fund fee), meaning your $110k grows only to $311,949 after 20 years. If you go to Fidelity, Vanguard, or Schwab, you can self-administer the account without an advisor, completely sans fees. If it is very important to you to have an advisor, you can easily find a lower-cost advisor who will charge only around 0.25% to babysit the index funds in your account and consult with you on an ongoing basis.
You have good instincts to ask this question. The math lays out the answer for you pretty clearly.
I am not certain that rates of 2/3 of a percent are high if the funds are active, providing alpha and appropriate for you. You could move the funds to another place if you dislike the bank or the advisor; you could add new money into lower cost options such as ETF that mimics the S&P 500 which is likely available at 5 basis points. I think that what you really need to do is decide what is a fair price to pay. The tax on the cap gains will be hard to swallow and recoup, but you have to look at your overall portfolio and determine how long the break-even period is.
Is it the investments themselves that you don't like, or the fees the bank is charging to manage those investments? I ask this because if you transfer the account to another investment company but keep the same shares of stocks/bonds/mutual funds/ETFs, there won't be a sell of the shares for gains. You'll just be trading one holding company for another.
Let's say you want to sell all of the investments and start fresh. On $29,000, the normal 15% long term capital gains rate (assuming you are not in the highest income tax brackets) will cost you $4,350. Assuming you save .4%/year on average (you won't be getting investments that charge nothing), that savings is $440/year. It will take you about 9.8 years to make up the capital gains cost with just the lower fees.
Consider ways to slowly move appreciated assets (combining with investment losses, charitable gifting with shares) so that you don't take a huge tax hit all at once. Also, look at the funds in context of more than just fees. A managed large cap stock fund expense ratio is around .6%. Index funds are less, but overall your bank may be in line with averages for the industry.
Think about it a second: Your funds have gained $29K on an $81K investment, or about 36%. Assuming you are in the 20% bracket you will owe $5800 in taxes if you sell. (You may also owe state taxes too, if you live in a state with income tax.) $5,800 is 5.3% of your total account. You don't like fees of about 0.7%, so you're willing to pay 5.3% to end the pain? That doesn't make much sense to me. Even the cheapest index funds charge a management fee. So if you save a half-percent per year it will take you more than ten years to make up what you lost to the government by selling. (More, if you pay state income tax.) But only if the performance of what you might buy will equal the performance of what you now own. Ask yourself: How has my account performed, net of fees? You should expect them to be behind their benchmark by 0.7% per year, so if they have done better than that, you fees have bought something worthwhile having.