A Taxing Investment Issue for Fiduciaries

Fiduciaries must temper investors' attraction to high returns, which can often result in the payment of unexpected taxes and exposure to unexpected losses.

W. Scott Simon


Many investors gaze longingly at the track record of big gains generated by a highly performing, stock-laden mutual fund and may decide to invest in it. This attraction is understandable since everyone wants big gains–if for no other reason than it provides bragging rights at cocktail parties.

Such behavior, which can be characterized as “track record investing,” is based on the simple belief that an investment which has done well (or poorly) in the past as shown by its track record will continue to do well (or poorly) in the future. Both kinds of belief make it appear that investing is easy: Just invest in a 5-star track record and don’t invest in a 1-star track record. Morningstar’s Don Phillips has warned repeatedly through the years, however, that the Morningstar rating for funds, which measures risk-adjusted performance from the past, should not be used as the sole means by which to identify investments that will beat (or be beaten by) their fund peers or the market in the future.

Many investors have a difficult time understanding this, but even when they do, they may have an even more difficult time accepting it. This was reflected in the first question asked to me when I was on a speaking tour in the upper Midwest this fall: “How often do you change your own portfolio based on the performances of the investments you hold?”

The questioner’s eyebrows shot up to his (receding) hairline when I replied: “I really don’t concern myself with what my investments–and, by extension, the financial markets in which they are invested–are doing, because I don’t have any control over them. Instead, I focus on the controllable, which is to invest in a low-cost portfolio that diversifies risk deeply and broadly.” The questioner was perplexed that I wasn’t “doing lots of stuff” with my portfolio because, after all, any responsible investor would certainly engage in such activities.

In fact, though, the return on any given investment for any given time period– whether a year, a month, a week, a day, an hour, or a minute–is simply a random variable subject to inherent uncertainty. In short, no one can know today what the actual return will be on an investment in the future. Even though investors have no ability to control the uncontrollable–namely, return–ironically, they often focus solely on return in determining what investments to select for their portfolios.

Although it’s obvious that investment winners and losers will be revealed in a track record for any given (past) time period, the insoluble problem, of course, is that no one can know the names of those winners or losers today, in advance. Billions of dollars in marketing costs are expended every year by mutual fund families, banks, insurance companies, and the like to obscure–largely successfully–this essential fact of investing and keep it from investors. This provides such entities with a more pliable marketplace that will more readily buy into their latest, greatest goofy investment ideas.

A mountain of robust academic studies over the last half-century has demonstrated convincingly that there’s no reliable way to predict when–or which, or even if– investment winners (or losers) from the past will win (or lose) again in the future. In fact, data from these studies show the perverse tendency for many superior track records to be followed by inferior track records, and vice versa. So, for example, just after an investor purchases a highly performing mutual fund, the fund may go down in value, or just after the investor sells a poorly performing fund, the fund may go up in value. The plain but rarely noted truth is that any investment that has performed well (or poorly) over any given time period in the past is just as likely to perform poorly (or well) in the future as it is to continue doing well (or poorly).

The 1992 Restatement (Third) of Trusts, a legal treatise that’s the Bible of modern prudent fiduciary investing, summarizes the findings of these studies: “Evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above market returns in subsequent periods.” And that fact is precisely why the U.S. Securities and Exchange Commission requires every mutual fund advertisement to include some form of the following warning: “Past performance is no indication of future results.”

Tax Implications

Wholly apart from these basic yet rarely noted issues is another one: Investors deciding to invest in a mutual fund with a recent track record of big gains will face a number of tax issues that few understand, and far fewer even know about. They are unlikely to have any idea that they may have to pay taxes on those gains–even though they never received the benefit of the gains. The following helps explain why holding such funds may require payment of unexpected taxes:

Suppose that an investor purchases shares in a high-flying stock mutual fund. Any such purchases are made at the fund’s net asset value (NAV), which is calculated daily. (Sales of fund shares are also made at the fund’s NAV.) As a fund shareholder, the investor acquires the existing unrealized capital gains that are embedded in the fund. “Unrealized” capital gains are increases in the values of mutual fund shares, but since they are only “paper profits,” they are not currently taxable. When a mutual fund manager sells fund shares, unrealized capital gains become “realized” gains, thereby making them taxable to fund shareholders. Shareholders must then pay taxes on any capital gains realized and distributed to them in the tax year when the fund shares are sold by the fund manager. (By the way, a second taxable event can occur that has nothing to do with the actions of a mutual fund manager but rather those of an investor. That is, when investors sell off fund shares from their own portfolios, they may be taxed on any gains that they realize.)

When an investor purchases a mutual fund, then, he or she not only acquires the fund’s existing embedded unrealized capital gains but also the fund’s embedded potential tax liabilities associated with those gains. For example, suppose that an investor buys shares in a highly performing mutual fund on Jan. 1, 2014, and that the fund earned unrealized capital gains in 2012 and 2013. If those gains are realized in, say, 2014, the investor would have to pay taxes on unrealized gains that were accrued in 2012-2013, even though he or she wasn’t invested in the fund in those two years.

While it’s difficult to believe, in such situations investors must pay taxes on capital gains they never got the benefit of receiving. Talk about taxation without representation!

The moral of the story: The attraction to high returns can often result–sooner or later–in the payment of unexpected taxes. The larger the portion of unrealized gains, the larger the potential exposure to realized gains and any associated taxes that must be paid on them. This calls for an investor who is thinking about investing in a stock mutual fund with recent large gains to check what portion of the fund’s NAV is composed of unrealized capital gains. Morningstar can help investors here. It provides estimates of embedded unrealized capital gains in the Fund Report for the mutual funds that it covers under the “Tax” tab.

Risk and Return

An investor thinking about investing in a high-flying mutual fund should be aware that risk and return are always related. Few investors think about this important principle of investing. Yet the Uniform Prudent Investor Act, which governs the investment conduct of fiduciary investors, states in its Prefatory Note that the “central consideration” of all such fiduciaries–who are responsible for other people’s money–is to identify the trade-off between risk and return in a portfolio.

This is important, because even a portfolio that’s currently experiencing soaring returns always carries the risk that it may experience plunging, negative returns at some unexpected time(s) in the future. This now completes a possible mother of all triple whammies in the preceding “taxation without representation” example: an investor having to pay taxes on capital gains he or she never received while watching a stock-heavy portfolio plunge in value.

The central consideration of all investment fiduciaries argues for a conscious assessment of portfolio risk–as well as return–through diversification, preferably broad and deep. An undue focus on return–which is precisely what track record investing is–can violate this primary duty of a fiduciary. Seeking only to maximize return–which may begin with a fiduciary’s lustful gaze at the track record of a high- flying mutual fund–doesn’t take into account the element of risk. Indeed, holding a large number of stocks with the objective of maximizing expected return not only doesn’t account for risk but can actually be quite risky. This is why investment fiduciaries must consciously think about risk as well as return. They cannot let the trade-off between risk and return just happen. Yet many fiduciaries (as well as investors in general) pay no attention to this simple requirement and, as a result, fail to undertake the central consideration they are charged with under the Uniform Prudent Investor Act, which is the cornerstone of modern prudent fiduciary investing.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

Share this

Share on facebook
Share on google
Share on twitter
Share on linkedin
Share on pinterest
Share on print
Share on email