What separates outstanding financial advisors from the mediocre? In my experience, one answer is the ability to learn from past mistakes and make adjustments. For many advisors, it is now possible to look back at the past decade and see a mistake that was costly to many clients.

The mistake was to buy into a story created by the mutual fund industry that went like this: “Most investors with long-term objectives should not try to time the markets. They should buy and hold an asset allocation program implemented with actively managed mutual funds that are automatically rebalanced periodically.”

The mutual fund industry profits to the extent that it can capture and keep stable long-term assets, and this story served that purpose. But it hasn’t helped millions of investors make much progress with assets held outside tax-qualified retirement plans, when all costs (including taxes) are considered.

Non-qualified money represents about half of the U.S. mutual fund industry’s total assets, and perhaps two-thirds of fund assets influenced financial advisors. Over a whole decade, investors netted on these assets just 58% of the gross earnings in U.S. domestic equity mutual funds, on average. The other 42% went to costs and taxes.

In this article, I’ll explain the “58% mistake” using comprehensive data published by Lipper. Then, I’ll suggest specific steps you can take to implement a more rewarding investment model in the future.

Pre-Liquidation Performance and Ratios

Lipper Research recently published a comprehensive 310-page report called “Taxes in the Mutual Fund Industry 2003″ to document performance of every major mutual fund category over the 10-year period 1993-2002. You can download it here:

The report quantified more than the tax impact fund investors absorb. For each fund category, Lipper also determined the ARR actually kept in a non-qualified account of a buy-and-hold investor after management fees and expenses, sales loads, and taxes. Federal taxes were presumed to be paid at the highest federal rate (then applicable) on each type of distribution, but state and local taxes were ignored. So, Lipper’s tax impact approximates that of an investor who is near (but not at) the top bracket, assuming federal, state and local impact.

Lipper calls this return “pre-liquidation performance, ” meaning that the buy-and-hold investor is assumed not to have sold any shares over the 10-year period.

Lipper’s bottom-line results are difficult to decipher only because they are spread over such a lengthy report. But when summarized, this data should be troubling for any long-term investor who buys and holds a static mix of mutual funds outside retirement plans. Over the full 10 years:

  • The “gross” ARR of all mutual funds in Lipper’s U.S. domestic equity category was 8.96% before management fees and expenses, loads and taxes. This was slightly below the S&P 500′s 9.34% return over the same period, as expected because of mutual fund portfolio trading costs.
  • However, the pre-liquidation ARR of all U.S. domestic equity funds was just 5.19% over this period. The total of management fees and expenses, loads and taxes was 3.77% per year.
  • Federal tax claimed 2.27% of the investor’s annualized return during this decade. Management fees and expenses claimed 1.30%, and sales loads 0.20%.
  • The ratio of the pre-liquidation return to the gross return was just 58%. The higher the “pre-liquidation ratio,” the more efficient funds are for buy-and-hold investors, after costs and taxes.
  • There was virtually no place for the non-qualified mutual fund investor to hide from the heavy impact of costs and taxes. With two exceptions, every Lipper long-term category produced pre-liquidation ratios below 70%. The two exceptions were S&P 500 Index funds and general municipal bond funds, both of which had pre-liquidation ratios of 81%. (See table below.)
  • For virtually all fund categories, pre-liquidation ratios were modestly lower than shown in the table, when no-load funds were removed from the calculation; i.e., when a professional financial advisor was involved.
Mutual Fund Efficiency by Lipper Category

(1993-2002 Ranked by Pre-Liquidation Ratio

Lipper Category Gross Return (ARR) Pre-Liquidation Net Return Pre-Liquidation Ratio Annual Portfolio Turnover Annual Tax Cost
S&P 500 Index 9.40% 7.6% 80.9% 9.0% -1.2%
General Muni Bond 6.70% 5.4% 80.6% 80.0% -0.1%
Small-Cap Core 11.60% 8.1% 69.7% 52.0% -2.0%
Mid-Cap Core 10.70% 6.9% 64.9% 79.0% -2.4%
Large-Cap Core 8.70% 5.2% 60.3% 67.0% -2.0%
U.S. Treasury 8.50% 5.1% 59.6% 53.0% -2.6%
Large-Cap Value 9.50% 5.7% 59.5% 54.0% -2.3%
Mid-Cap Value 11.60% 6.9% 59.3% 65.0% -2.7%
Small-Cap Value 9.90% 5.8% 59.0% 78.0% -2.2%
Equity Income 9.50% 5.6% 58.4% 48.0% -2.5%
Balanced 8.40% 4.6% 55.1% 83.0% -2.3%
Income 8.80% 4.7% 53.1% 47.0% -2.8%
General Bond 7.70% 4.0% 51.6% 44.0% -2.6%
Convertible 9.50% 4.8% 50.7% 95.0% -2.9%
Flexible Portfolio 8.10% 4.1% 50.3% 96.0% -2.4%
International Equity 6.10% 3.1% 49.8% 60.0% -1.5%
U.S. Govt. Bond 7.80% 3.9% 49.6% 198.0% -2.5%
Mortgage 7.40% 3.6% 49.2% 182.0% -2.6%
Large-Cap Growth 7.00% 3.4% 48.9% 86.0% -2.2%
Global Equity 7.80% 3.8% 48.0% 139.0% -2.0%
BBB-Rated Bonds 8.20% 3.8% 47.0% 247.0% -3.0%
Mid-Cap Growth 7.50% 3.1% 41.7% 101.0% -2.6%
Small-Cap Growth 7.20% 2.7% 38.0% 106.0% -2.7%

In summary, over a full decade, the average investor who participated in a mix of buy-and-hold mutual funds held outside retirement plans, implemented by a financial professional, did worse than a team of monkeys throwing darts at a list of individual securities. That’s because of the high cost and tax impact of mutual funds, compared to individual securities. If you bought and held all 500 securities in the S&P 500 Index, for example, your pre-liquidation ratio would probably be about 90% over a full decade. In a passively-held mix of mutual funds, no amount of successful active management at the individual fund level can overcome the difference between keeping 90% of gross return and 58% over a period of time.

It is true that you would probably have a larger built-up capital gain position in the individual securities portfolio, after holding a decade. But you would also have more flexibility regarding timing, for tax recognition purposes. If you died holding the individual securities, capital gains would disappear through stepped-up basis.

The Cost of Automatic Rebalancing

Another part of the mistake involves automatic rebalancing of mutual fund allocation portfolios. When taxes and expenses are considered, automatic rebalancing is usually a losing proposition. In some ways, the 10-year period studied by Lipper should have been a classic case supporting the need for rebalancing. For example, during the late 90s, if you had rebalanced systematically from growth stocks into value stocks, or from stocks into bonds, wouldn’t you have done better than just sitting still? The answer is probably not, for two reasons. First, you would have missed part of the huge upside in growth stocks versus value, or in stocks versus bonds, in 1997-1999. Secondly, your returns would have been further reduced by extra tax costs.

In 1996, for example, the average gross return of all Lipper U.S. Domestic equity funds was 21.49%. On a pre-liquidation basis, the buy-and-hold investor would have earned 14.16% after costs and taxes. But on a post-liquidation basis (assuming shares were sold at the end of the year), the return declined to 11.05%. Automatic rebalancing turns pre-liquidation investors into post-liquidation investors on part of their portfolios, and the post-liquidation tax bite is greatest when market performance is strongest. We didn’t know this conclusively before the Lipper report. But we know it now.

Since automatic rebalancing is a mechanical process, it doesn’t add strategic value or insight to offset the extra cost. For example, the most valuable financial advice any client might have received over the last decade would have been to “take some stock market gains off the table” in 1999 or early 2000. Such a strategic asset allocation move – one that adjusts allocation guideline percentages based on professional insight – does increase costs, but also has a value-added purpose. If an advisor can accurately adjust an asset allocation model every year or two, the strategy can have powerful positive impact on portfolio performance, regardless of whether portfolios are implemented with mutual funds or individual securities.

How to Correct the 58% Mistake

The buy-and-hold asset allocation fad lulled some financial advisors into thinking they could put investment planning on autopilot and make clients feel successful and satisfied. But it didn’t fly from 1993-2002, and it won’t fly in the future. To be competitive, you need to offer clients clear guidance on where markets are going and help them make strategic allocation moves on a timely basis. Reject any concept that includes the phrase “automatic.” The best way to maximize pre-liquidation returns is to customize portfolios and tax planning to personal needs.

You can offer clients asset allocation programs that are strategically driven and also cost- and tax-efficient, with pre-liquidation performance ratios exceeding 80% of gross returns. That should be your goal with non-qualified long-term assets, and the ideas below will help you achieve it.

  • Be active. A static mix of mutual funds will almost always be inefficient over a lengthy period, but that’s not necessarily the case for an actively-managed allocation mix. Mutual funds offer one cost advantage over individual securities – free exchanges among funds in a family. If your investment model calls important market trends perhaps once or twice a year, you can add value with an allocation model that includes some mutual funds while keeping costs reasonable.
  • Avoid “wraps” for long-term investors. The Lipper data documents the futility of trying to make long-term investment progress in mutual fund wrap accounts. These accounts replace the portion of costs allocated to sales loads (0.2% annually) with a wrap fee that can be 1.0% to 2.0%. If a wrap fee in the middle of this range had added 1.2% per year to total costs (net) over the last decade, the investor’s pre-liquidation ratio could easily have been below 50%.
  • Avoid tax-efficient analysis – The Lipper report underscores what a difficult job it is trying to evaluate and select tax-efficient funds for your clients, when the whole category (mutual funds) is so tax-inefficient. For example, portfolio turnover is often used as a quick screen of tax-efficiency, but Lipper observed that it is not always reliable. Some high-turnover fund categories (and individual funds) can be more tax-efficient than low-turnover peers. Performing accurate analysis of mutual fund tax-impact is a difficult and time-consuming job, for which you should be paid. Actually, it’s an added cost of mutual funds, compared to alternatives.
  • Be careful with index mutual funds – Lipper observed that some index mutual funds are not as tax-efficient as previously thought, due to forced liquidations in down markets and index reconstitution events in all markets. Substituting exchange traded funds (ETFs) for index mutual funds can add 10% or more to pre-liquidation ratios.
  • Keep the baby – Don’t throw the baby out with the bathwater, because there are viable ways to help your clients achieve 80% or better pre-liquidation ratios with some actively-managed mutual funds in their portfolios. Mutual funds remain the most efficient way to participate in tax-exempt municipals with broad diversification. Also, as Lipper observed, a small but growing group of “tax-managed funds” seek high tax-efficiency as a matter of policy.
  • Rethink the role of bond funds in asset allocation – Bonds are often used to temper risk in asset allocation programs, even for investors who don’t need current income. But Lipper data shows that some bond fund categories have even lower pre-liquidation ratios than stock fund categories. There are more efficient ways to temper risk, including the use of low-correlation, low-income asset classes.
  • Capital gains for income – For investors who need current income and have modest to high risk tolerance, the most efficient way to generate income is to take long-term capital gains from ETFs or individual securities. The current gap between the highest federal income tax rate on ordinary income (35%) and long-term capital gains rate (15%) is as wide as it has been in your lifetime.
  • Be careful with small/mid-cap growth stocks – These categories ranked at the bottom of Lipper’s study in pre-liquidation efficiency. If you insist on using mutual funds in allocation programs, it may be best to avoid these inefficient asset classes (for non-qualified accounts).
  • Keep variable products in mind – The Lipper report makes variable annuities (and variable life insurance) look more attractive, relatively speaking, due to their tax-efficiency. If clients find guarantees or mortality-based benefits worth the extra costs, variable products may make sense for long-term non-qualified assets.
  • Recognize change – Today’s market is very different than the one of a decade ago. More data like Lipper’s is available to measure portfolio efficiency. Investors have more choices like ETFs and separate accounts for increasing efficiency. Technological advances make it more economical for individuals to control their own tax basis and costs. Also, many investors have lower expectations as a result of the bear market, and this has made them more cost-conscious. They aren’t willing to take the risks of equity mutual funds to net 4% after costs and taxes.
  • Be bold – The industry of the future is not going to pay financial advisors much money to build cookie-cutter asset allocations and rubber-stamp them every year. The industry will reward advisors who create efficient top-down allocation models and then adjust them dynamically and strategically with low-cost implementation tools that allow personal tax-tailoring. You need a solid investment model to guide your advice, better and bolder than your competition is offering. The challenge of the future is to develop a model that is personalized, risk-sensitive and cost-efficient while getting paid adequately to monitor and adjust it.

Go for it!