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.
Mutual funds can be expensive. And you will still be paying these fees whether or not they are performing. There are alternatives to mutual funds where you can still have diversification of a fund but are structured differently. Regardless of what financial firm you are doing business with, although it sounds like you are not getting the management you desire. Dealing with a firm that offers a mix of differing investment products could be more advantageous for you. Also having a financial advisor to offer you some alternatives and different strategies.
Here are a few alternatives you may want to consider:
1) Unit Investment Trusts (UIT): This is a fixed portfolio of securities that have terms of 12 months up to several years. There is an upfront fee. No other fees associated with a managed mutual fund.
2) Exchange Traded Funds (ETF): This is traded security that tracks an index, bonds, or a portfolio of assets much like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold.They have lower fees than mutual fund shares.
3) Closed End Funds (CEF): Closed-end funds are technically a type of mutual fund, but they combine elements of regular open-end mutual funds and ETFs. Like open-end mutual funds, closed-end funds give you a stake in a larger pool of stocks or other investments, sharing expenses with fellow shareholders. However, unlike regular mutual funds, CEFs trade directly on stock exchanges just like ETFs do, and their prices can change throughout the market day. Closed-end funds also have a fixed number of shares outstanding, which are first sold to the public in initial public offerings like stock and then subsequently offered in secondary offerings after the IPO. Because of the limits on their share counts, CEFs can trade at a premium or a discount to their net asset value, and that can be profitable for value investors.
The bottom line is that mutual fund fees are rising as funds shift away from the up-front loads that are driving away sales and into the annual expense ratios where they are not as detectable. And these fees are charged every year whether or not the fund has performed.
The other issue with mutual funds is the high turnover of assets in the fund. Buying and selling stocks have transactional costs which cut into the net return. A fund with a high turnover will end up distributing yearly capital gains to their shareholders and that will generate a tax bill for the investor thereby reducing net returns.
Additionally, mutual funds are required to maintain liquidity and the capacity to accommodate withdrawals. Funds typically have to keep a portion of their portfolio as cash. The funds are keeping cash balances of usually around 8% of the fund, which is not generating any returns.
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.
Depending what you own the expense rates aren't that high. But moving away from your current bank should be easy unless it's a proprietary product. Since it sounds like you have a non-qualified account (otherwise taxes would be deferred in an IRA), you could do an ACAT transfer in kind of the funds do another brokerage firm (shouldn't generate any taxation nor sell the positions) and then sell them in the most tax effecient manner that makes sense for yourself over time. Of course, that is assuming you would want to sell them at all. Expense rates are definitely not the ONLY thing you want to look at. There are plenty of international or smart-beta ETFs that have higher expense rates then cap-weighted index funds...doesn't mean they are bad, it's just the cost for what they offer.
Hope that helps.