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Why We Invest in Mutual Funds

What is the most prudent way to invest, given the objectives of our clients and the uncertainties of the investment markets?

By Jim Miller, CFP, President & CEO

Our Investment Process
Our investment process was established to address the question posed above. Figure 1 (at right) illustrates the key stages of our investment process.

Based on an understanding of the client’s unique situation, their objectives and their feelings toward risk, we establish an appropriate broad investment strategy. Each investment strategy has unique risk and return characteristics that determine how much will be invested among stocks, bonds and money market funds.

A key defining characteristic of our process is our focus on tactical asset allocation— looking for opportunities to increase returns or reduce risk by changing the amount invested in the various asset sub-categories and investment styles. A great deal of research and analysis is continually put into these decisions as we monitor the investment markets and our clients’ portfolios. Our focus on tactical asset allocation is a key distinction from many other investment approaches. Investment categories that we actively research and consider for inclusion in our clients’ portfolios include:

• Larger-company Stocks
• Smaller-company Stocks
• International Stocks
• Investment-grade Bonds
• Lower-quality Bonds
• International Bonds
• Commodities
• Real Estate Investment Trusts (REITs)

Examples of different investment styles we use include:

• Value
• Growth
• Growth at a Reasonable Price

We make tactical changes to the amount we invest in each of these categories and styles to take advantage of opportunities. These opportunities are often presented during times of market turbulence, when there is a great deal of fear or pessimism among investors and specific asset classes are driven down to bargain prices. In contrast, opportunities to reduce risk arise when there is unwarranted exuberance among investors and certain asset classes are driven well above what reasonable valuations can justify.

Implementation
Following the decision regarding how much to invest in each investment category, we need to implement the strategy. Investment vehicles available include individual stocks and bonds, mutual funds and separately managed accounts (an approach that hires multiple managers who each purchase individual securities on the clients’ behalf). Merchants Trust Company has carefully considered each of these investment vehicles and believes mutual funds are the most prudent vehicles to use for our clients’ portfolios. The remainder of this article will discuss why we prefer the use of mutual funds to other available options.

Efficient and Cost-Effective Method of Changing Exposure to Asset Classes
Changes to our client portfolios are most often a result of a change in our outlook for a specific asset class. When we identify an undervalued asset class, we prefer to invest quickly and in a manner that provides us with broad exposure to the asset class. We also wish to avoid any unnecessary expenses. Mutual funds are superior to individual securities as vehicles for making these tactical changes among asset classes. When we buy and sell mutual funds, there are no transaction costs involved. Buying and selling individual stocks involves commissions and there can be significant costs involved when buying and selling individual bonds.

Timeliness, accuracy and cost effectiveness are equally important for rebalancing. Due to the natural fluctuations of the market, portfolios deviate from their target allocations. Mutual funds provide a precise method of bringing the alignment of the several asset classes and styles back in line with their target allocations.

There are also times when a client’s tax situation dictates a change within the portfolio. For example, if a client moves from a high tax bracket to a low tax bracket, it may be advantageous to move from tax-exempt bonds to taxable bonds to generate a higher after-tax yield. This can be done with mutual funds, without any transaction costs. Making this change with individual bonds might result in a cost to the investor of more than 3% of the value of the bonds.

Diversification
Mutual funds provide professionally managed and diversified exposure to multiple asset classes in a manner that is very difficult to achieve with individual securities. Proper diversification is a critical component of managing portfolio risk.

After-Fee Performance
Mutual funds charge a fee for managing fund assets. This fee is an important factor in our fund selection process. We will only hire a manager if we are confident that they will generate a long-term investment return that beats the market benchmark by an amount that exceeds their fee. While the fee is a significant factor, more important is the value we are getting for the fee.

Tax Efficiency
The most tax-efficient method of investing is to purchase individual securities, hold them until death, and then following a step-up in the cost basis to the value on the date of death, heirs can sell the securities with little or no gain. While this is certainly very effective in minimizing taxes, it may not be successful in generating the highest after-tax rate of return. To do so requires the insight and wisdom today to select securities that will be the winners several years or decades into the future.

Any method short of holding until death only defers paying tax. (An exception would be if the value of the security subsequently declines and is sold at a loss—an even more desirable tax result!) Taxes must be paid sooner or later. What is lost is the time value of the money paid in taxes today, which otherwise could have been reinvested. By paying some taxes now, the tax liability when you ultimately sell is reduced. The impact of paying the taxes each year, rather than paying it all when the fund is sold, is actually considerably smaller than most people think. It should also be noted that while deferral of tax is generally favorable, if the capital gain tax rates increase in the future from today’s favorable rates, it may be advantageous to realize gains today. (See figure 2, at right)

An alternative to buy and hold is to actively manage a portfolio of individual securities. If the manager recommends a change, the investor can always opt out of the change if they wish to avoid the capital gains that would be realized from the sale. But doing so will be contrary to the recommendation of the manager (who was hired because of their expertise). For example, when a manager recommends the sale of a stock, it can be assumed that it is because they believe it is no longer the best investment for the portfolio. They are selling the stock to replace it with an investment that they believe will generate a higher return. They are making the change at the time they believe to be most advantageous. If the investor opts out of or postpones the sale and continues to hold the stock, they will defer capital gain income, but possibly at the cost of a lower investment return (assuming the manager is skilled at managing their portfolio and selected a superior investment).

The use of mutual funds requires delegating control of security selection to the fund managers. The investor has no control of the amount of capital gains that will be realized and passed through by the fund each year. This is far from ideal, however, we believe enabling skilled managers to make timely buy and sell decisions, with an objective of generating the highest investment return, is in the best interest of our clients. While no one enjoys paying taxes, tax avoidance should not dictate investment decision making.

We believe that mutual funds are the investment vehicle that provides us with the best chance for success. This success does not hinge on the success or failure of the mutual fund industry at large, it only requires the ability to find a small number of good funds within this large and highly-imperfect industry. This is what we do, and we can say with confidence that we are able to find enough high-quality fund investments to be successful.

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