Archive for July, 2008

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The Dangers of Embedded Tax Liabilities in Mutual Funds

July 30, 2008

This post continues a discussion I’ve forwarded about the inadequacy of current mutual fund disclosure regulation. In a previous post I’ve talked about the need for additional disclosure about mutual fund fees.  Now we turn our attention to taxes, and how unsuspecting mutual fund investors can be saddled with a tax bill they had no part in creating.

If you hold shares in a mutual fund outside of a tax-deferred retirement plan you no doubt receive information each year on the amount of money the mutual fund distributed to you in the form of taxable dividends and/or capital gains. For a detailed explanation of how mutual funds create tax liabilities click here. What mutual funds are not required to disclose is their potential capital gains tax liability. And at risk of boring you to tears I am going to provide a simple example so that (hopefully) it is clear why this matters.

Suppose a mutual fund company currently owns two shares of the company HiTech. The shares were purchased by the fund at $5 per share and are currently selling for $10 a share. The fund has issued two shares of its own, owned by Bill and Mary. The current net asset value per share of the fund is thus $10 per share.  Now suppose Ron buys a share of the fund for $10. The fund uses the proceeds to buy another share of HiTech. The fund now owns three shares of HiTech with acquisition costs of $5, $5 and $10.

Now suppose the stock of HiTech drops to $9 per share. This drop causes the net asset value per share to drop to $9. Bill and Mary decide to redeem their shares. To meet this redemption, the fund sells two shares of HiTech with the cost basis of $10 for one share and $5 for the other. This generates a realized capital gain of $9-$5 = $4 for the share purchased at $5 and a realized capital loss of $1 for the share purchased at $10. So, there is a net captial gain of $3. This capital gain must, by law, be distributed to the remaining shareholders. So, in this case, Ron recieves a capital gain distribution of $3. The net asset value of the fund falls to $6 per share and, assuming reinvestment, Ron now owns 1.5 shares.

Although Ron has experienced an investment return of -10%, he will still face this capital gains tax. If capital gains are taxed at 15% he must pay 45 cents in taxes. So, even though Bill and Mary walked away with the investment returns, Ron gets left holding the tax bag and must pay the federal goverment the taxes that Bill and Mary’s investment returns created.

Some mutual funds, particularly equity mutual funds, have large embedded tax liabilities of just the short described here. If they needed to sell assets quickly to generate cash those who did not exit the fund right away would be stuck holding the tax bag. Most people don’t know much about what I’ve just written here, but you can bet that if it happened at large enough scale (like during a sizable economic downturn) the press would quickly notice it and that investors would quickly exit these mutual funds — in a way not altogether different than a bank run — to avoid these tax implications.

At a minimum, individuals should be given information sufficient to determine whether a fund they are thinking of investing in has a large or small embedded tax liability. Without this disclosure, there are serious and often-unknown financial risks to savings invested in mutual funds. The SEC should mandate this disclosure. If they do not, the House Financial Services Committee should write legislation requiring the SEC to do so.

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Brooks Comments on Morgenson Article

July 22, 2008

David Brooks is certainly paying attention to the idea of thrift and debt. In the second time in as many months he weighed in on the issue, this time reacting to an article by Gretchen Morgenson in this Sunday’s New York Times. The Morgenson article has spawned a great deal of blog commentary — predictable stuff given the content of the article. The central argument that is being played out is a very old, in in some sense politically intractable, one. How much are individuals to blame for their own reckless behavior versus how much the government should protect people from those who would seek to take advantage of this behavior? In the typically shrill voices of blogs and Internet-posted comments, plenty of people claim to know the answer.

I don’t know the answer.

I find these kinds of arguments rather meaningless, Internet-enabled screaming that gets us nowhere. That is why over the course of the next two weeks I’ll post some proposed changes in law that will avoid the above argument entirely, focusing on some low hanging fruit that will help people protect and grow their savings.

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The Forgotten Issue

July 20, 2008

Here is an updated and expanded commentary on the presidential candidates’ positions on some important issues with respect to household savings. It is in the form of an editorial published in Financial Week magazine.

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Reaction to The Weekly Standard Review.

July 19, 2008

My book was reviewed this week by The Weekly Standard’s Irwin Stelzer.  Founded by William Kristol, The Weekly Standard is a clear and thoughtful voice for conservative policy.

Mr. Stelzer liked the book, finding it both important and readable. He also found the  the discussion of why Americans don’t save more interesting and compelling than some of the policy prescriptions. His review was careful, accurate, and those “quibbles” he did have with parts of book were completely reasonable observations.

I thank The Weekly Standard for their decision to review the book, and Mr. Stelzer for his thorough reading of the material and lucid review.

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Men are Better Savers, Women are Better Investors

July 12, 2008

Women are better investors than men. I’ve written about this topic previously in this blog, and  I’ve also provided material to media outlets that have issues of gender and finance as one of the primary focuses of their communication.

But the story of men, women and money is much more complicated than one blog post or short article. And I want to briefly address another piece of the puzzle today. Yes, women are better investors, but they are also “worse” spenders in sense that they are more likely to be spendthrifts than men. That is one conclusion of a recently published paper,  “Tightwads and Spendthrifts”, but the kernel of this particular result has been known at a practical level to marketers for quite some time.  Women are better at, and enjoy, shopping more than men because of an evolutionary propensity to remember where objects are located, or are hidden. This is particularly true in the case of food. In early societies men hunted, and developed skills (physical strength, spacial geometry) that helped them in their daily activities as hunters. Women gathered — food mostly. They are better at it today because their own and their offprings’ survival depended on this skill for thousands of years.

But much like men’s hunting instincts help make them inferior investors to women, women’s gathering instincts can wreck the budget as well. They are good at shopping and so they enjoy it. And enjoying shopping too much….well we all know where that leads.

So how does this knowledge lead to practical advice for household finance. Well, current research certainly suggests that for couples, in more cases than not, it would be better for men to handle the day-to-day budgets and then once money is set aside as savings for women to do the investing. The interesting part of this advice is that it runs counter to what I, and I suspect many of us, have observed is the case with married couples that we know (women set the budget, men invest the savings). These more traditional roles appear to be at odds with healthy household finances.

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