Author: A.T.

Greg Buliavac: “OK, I haven’t looked at your mutual fund cost calculator, but my question is, why do you need to consider the costs of a fund? Why don’t you look just at the performance numbers, since performance is calculated after costs are subtracted?”

This is exactly the right question and a lot of you have asked it. We try to answer it in what I guess is too hidden a place on the Mutual Funds Cost Calculator site. (You reach it by clicking “more” on the first page.) Click here for a direct link. Two sections are most relevant: Because Predicting Costs Is Much Easier than Predicting Performance . . . and . . . But Don’t You “Get What You Pay For?”

But if you have time, read it all and let me know what you think.

Rodney Skidmore doesn’t buy it. He writes: “Give me an ‘expensive’ manager that delivers over a low cost manager that loses money, any day.”

Absolutely! Of the 11,000 funds out there, please list for me, below, any 3 that will significantly beat the market over the next few years on an after-tax basis:

1. _________________

2. _________________

3. _________________

We’ll check back a few years from now, and you’ll probably be rich and I’ll probably look like an idiot.

Even so, it’s just a lot harder finding these funds looking forward than back. Which is why instead of comparing a high cost manager that “delivers” with a low cost manager that loses money, I’d compare the high cost manager with a low cost manager that makes money — as so many do.

It’s counter-intuitive that really bright guys and gals who work at it can’t fairly consistently beat the market, and by more than the extra 3%-a-year handicap, say, that a high-cost, tax-inefficient mutual fund might have to bear. After all, in a normal environment, where stocks may be expected to return about 10% a year, having to do 3% better than the pack to cover the added costs — just to wind up doing average, that is, after costs and taxes are deducted from an investor’s return — is merely to have to do 30% better than the rest. And why should that be hard?

Well: it is.

And, with a high-cost, tax inefficient fund, that merely gets you even with the pack. Actually to beat the pack, you have to do better still.

I was riding up Sixth Avenue and saw that billboard with the National Debt in bright lights spiraling $10,000 deeper into hock with every passing second. It’s an astonishing thing, really, to see the numbers whirring fast enough to add $10,000 a second. The right-most digit . . . the one-dollar bills . . . must be racing around at 10,000 increments a second, if they actually do it right. (Maybe they round to the nearest $1,000, so it grows $1,000 every tenth of a second. Still makes for a heck of billboard.)

I’m not sure how many trillions of dollars ago it was erected; but this thing has been lighting up the avenue and making people feel bad for a long, long time now, 24 hours a day, 7 days a week, for years.

And the point is: It stopped.

It’s conceivable the sign was just broken the day I passed, but I don’t think so. The lights were as bright as ever, so the power was on.

No, it had stopped. <Partisan hat ON> The Clinton/Gore budget of 1993 . . . the budget that received not a single Republican vote but that was designed to appease the bond market and get interest rates falling so employment could start rising so the deficit could start falling instead of rising . . . that budget worked. And the Democrats want to maintain the same fiscal responsibility to keep the economy growing responsibly. No gargantuan tax cuts right now, thank you; that’s what you do when you need to give the economy a boost, not what you do when the economy is booming and unemployment is low. <Partisan hat OFF>

The point is: The National Debt Clock had stopped.

And somebody, someplace, is scratching his head wondering if it’s worth trying to run the thing backwards, or better to just replace it with something else.

With minor readjustment it could be a world population clock — 6 billion any minute now, up from 2.5 billion when I was born, and growing by a new Mexico every year. (Not a New Mexico, mind you — a new Mexico.)

Or if it can be rigged to run backwards, it could be a Remaining Acres of Rain Forest clock. Or a Remaining Population of Atlantic Salmon clock.

Or maybe it should just be turned into a billboard for Honest Tea.

Tomorrow: Why Consider Mutual Fund Cost at All When It’s Already Figured into Performance?!

What’s ordinarily thought of as double taxation of dividends is this: You own a company. It makes a profit. That profit is taxed once to the corporation, and then a second time when you receive it as a dividend. (Corporations have been prety aggressive in getting around this by finding ways to pay little or no corporate income tax, and by paying out little or no dividends. Many buy back their own stock instead, which in theory will give the value of your stock — and, especially, the value of management’s options — a little lift.)

But there’s another double taxation of dividends that’s inadvertent and entirely avoidable. I referred to it last week.

Lynn Smith: “You say: ‘I’m also assuming you are not accidentally double-counting as taxable gains appreciation from reinvested dividends. You’ve already paid tax on that portion of the growth in the value of your holdings. This is a common mistake.’

“I don’t consider myself a novice, but I’m not following your comment about double-counting. I’m taxed on it when I receive a dividend. The fact that I choose to reinvest that dividend income or just invest the same amount of regular old money has no bearing on whether its appreciation will be taxed. Both would be taxed equally when sold. What am I missing?”

Say you put $10,000 into a fund and check “reinvest dividends.” Now 5 years later, it’s $20,000. This is just great, and congratulations.

You sell.

Some people make the mistake of entering $10,000 as their cost, $20,000 as their proceeds, and pay tax on the $10,000 profit.

You, of course, have added to that original $10,000 cost the additional cost of all those additional shares you purchased by reinvesting your dividends — and on which you paid income tax each year.

Let’s say you got and reinvested $3,000 in dividends and capital gains over the five years. Where some might accidentally show $10,000 as their cost, $20,000 as their proceeds, and pay tax on the $10,000 profit, you show a cost of $13,000 and pay tax on only the actual $7,000 previously-untaxed profit. The folks who declare a $10,000 gain are paying tax on the previously taxed $3,000 TWICE.

Robert Doucette: “How do I figure out how much I would owe in Capital Gains from a mutual fund investment? I know how much was paid originally and how it is worth now, but every year we pay taxes on the funds in our taxable accounts? Surely we are paying the Capital gains on the installment plan?!?”

Same deal. If you’ve been reinvesting the dividend/gains distributions, you have to keep track of them (or get the fund to send you a recap). Add all your reinvested dividends to your cost for the original shares, so you get a total of all you’ve paid for the original, plus the additional, shares.

On the other hand, if you’ve been getting actual checks — and using them to pay the rent rather than reinvesting them — any gain in your account is taxable. It’s a gain on your original shares, which is all you have. If you paid $10,000 and sell for $17,000, that’s a $7,000 gain, plain and simple.

Yes, if the fund distributed lots of dividends and capital gains each year, you did pay a lot of tax along the way. But whenever it paid cash out, it also lowered its net asset value per share.

Shares you bought at $10 that rose $4 in net asset value to $14 and then paid out a $4 capital gains distribution are instantly, after the pay-out, back to $10. If you sell, there is no gain.

Indeed, while it’s not always a great idea to buy shares in a fund just before a large capital gains distribution is paid, it’s not quite the disaster people warn of, either. Say you paid $14 Tuesday and the next day, Wednesday, you got a $4 taxable distribution. Well, if this is going to cause you a problem, just sell the shares — now instantly $10 a share after distributing the $4 — and you will have a $4-a-share loss to net out the $4-a-share gain. (Of course, if this were a load fund, or a fund with a surrender charge, you couldn’t be so cavalier about it.)

Have I just left you more confused? Well then, enough mutual funds for a day or two.

Tomorrow: A Broken Clock That’s Right All Day

But first a quick one:

Remember Quickbrowse? Long-term readers were among the first to see it, and quite a few of you have used “Q-Page” to have this column delivered to you every morning. (To do that, just go down to the bottom of this column and click the Q-Page icon. Mornings when I’m late with it, you’ll get yesterday’s column again, but that’s my fault, not Quickbrowse’s.)

Well, guess what. It’s lunacy, of course, but wasn’t Marc’s dog Looe excited when we got a write-up in Red Herring last week. And then — arf! arf! — a follow-up where one Red Herring reader thought Quickbrowse might be worth “ten to thirty million!” (Not that we noticed any checks attached to his e-mail.) If anything comes of this, Looe — whose photo, over my protest, has been removed from the Quickbrowse site — will be in filet mignon for the rest of his waggy-tail life.

And now down to cases:

John McInnis: “You say, ‘If you’ve been buying shares in a high cost fund all along, sell the shares for which you paid the highest price but keep those you bought way back when.’ My question is: how exactly do you do this? In the olden days, when dealing with a flesh-and-blood broker, you would send him a note saying something like ‘Please sell the 100 shares of XYZ purchased on 4/1/66 and not the ones I bought last week.’ Of course the shares are all the same to your broker and you, but this polite fiction was sufficient to hold the IRS at bay. Nowadays though, with online brokerage accounts, how do we effect this little charade?”

Send the note anyway and keep a copy with your tax records. (Actually, since these are no longer the olden days, fax it and you won’t even have to make a copy.) You’re not likely to be audited, but if you are, and you have good records — along with clear instructions to your broker directing him to sell “the 300 shares versus purchase date 7/13/93” — it seems to me you’ve done your bit. (Don’t blame me if the IRS disagrees. I limit my liability in this to price you paid for this column.)

But you raise a good point. An enhancement on-line brokers could easily add is an optional field in which to enter the VSP date (VSP = versus purchase). The deep discounter I use has “beginner,” “intermediate,” and “advanced” display modes. So why not offer a VSP field on the advanced display? If a client enters a date, the confirm and monthly statement he receives should both reflect that VSP date.

Kevin Crawford: “The Cost Calculator is a great idea, but flawed. I found this out by typing in BARAX (Baron Asset Fund) and looking at your results. It said that other funds would do me better in the long run assuming all of the funds had the same return. The cost calculator does not seem to take into account that great fund management can make a big difference in the long run. And Ron Baron has certainly done that over the long haul (just not 1998, which for him was a complete disaster; but this year he is back on track). I would love to hear your thoughts on this and I need a really romantic resturant for NYC which I’m bringing my wife to in October.”

Well, if you don’t mind its not being famous or wildly extravagant, try La Boite en Bois at 75 West 68th Street (212-874-2705). Cozy, authentic French without being snooty, and $100 should take care of the whole deal including the wine, tax and tip. I have no connection to it other than having eaten there.

As to Ron Baron, the point of the Mutual Funds Cost Calculator is not that you should always ditch a high-cost fund for a low-cost fund (although generally that does make sense, especially where the cost difference is large and no taxes are incurred by doing so).

But here’s what we do believe, and what study after study shows: Over time, costs matter. A great deal. Over time, most high-cost funds do worse than most low-cost funds. It’s easy to spot great fund managers looking backward. But how do you spot a Ron Baron before he’s got his track record? (A track record I’ll get back to in a moment, by the way.) And once he does have the record — will it persist?

The longer the track record, the more confident you may feel in the fund manager’s exceptional ability. But look at the flip side of that. The longer the track record, the more of it is already behind the manager. You’ve missed all that. And then you have to wonder, hmmm . . . might this person, now that you’re finally satisfied of his or her skill and ready to invest — might this person have gotten a little fat and happy? Or cocky? Or might the “paradigm” have shifted? (Not that I have any better idea what a paradigm is than the next guy who pretends to.) Maybe this is a fund manager who was great in the old world, but now won’t be able to out-think younger tech-whiz managers?

For example, no one would dispute that John Neff was a great fund manager. He had the added benefit, running the Windsor Fund, of Vanguard’s very low costs. But in the last few years of his management, having convinced even the most skeptical of his talent, his fund’s legendary performance actually became a little less legendary.

As for BARAX, Morningstar shows its 10-year annualized total return at 13.91%. That compares with 17.28% for the S&P 500. I’m first to admit this has been a great 10 years for the S&P (and that BARAX was designed specifically to find smaller growth stocks). Still, $100,000 invested 10 years ago would have appreciated $267,500 in BARAX, versus about $390,000 in the S&P. So all that great stock-picking — and what some people regard as the extra risk of smaller-cap stocks — weren’t enough to beat the boring old cost-free “market” that the S&P more or less, sort of, represents. You would indeed, in this example, have left $122,500 on the table.

Even with a well known, super-bright, respected fund manager like Ron Baron I’m not sure that it’s wise to ignore costs. There’s no denying costs weigh down performance. And they’re one of the few parts of the investing equation you can more or less control.

And that’s the point of the Mutual Funds Cost Calculator. Bon appetit.

Monday: How to Specify WHICH Shares of a Stock or Fund You’re Selling

Mark D: “I have been enjoying your ‘heavy jockey‘ mutual-fund analogy, and was independently given the same advice by a nephew who toils away in the bowels of Goldman Sachs. But how can those of us operating with 401(k) accounts at our workplace do anything about it? Our employer makes a sweetheart deal with a big firm with a pompous name (and no index funds), and our only choice is among their various overburdened horses.”

Well, some others have told me they’re getting kinda sick of that jockey analogy, and I’m seriously thinking of switching to jet planes with headwinds. Or to swimmers wearing shoes. But the answer to your question is that — other than making some constructive suggestions to your personnel department (which is not impossible; things sometimes do change, given enough time) — I can’t think of much you can do about this.

I suppose that in this job market you might get a 25% raise and a better menu of 401(k) funds to choose from if you switched employers. (Disclaimer: The preceding was a humorous hypothetical. The author, his heirs, assigns, co-assigns, publisher or publishers, friends and acquaintances disclaim all responsibility for any adverse consequence that may result, now and in perpetuity throughout the universe, since time began, if you quit your current job.) On the other hand, if your employer is one of those that match your contribution 50 cents on the dollar, say, as many do (some do more, some less, some do nothing), then you really have a pretty great deal going, despite the high fund expenses.

One way to get your personnel department interested in this issue, and possibly writing memos to top management on an easy way to do something good for the employees, is to direct them to the Mutual Funds Cost Calculator and ask them what they think.

Remember, with a 401(k), at least the tax costs that make some jockeys so heavy (I noticed one at 765 pounds yesterday) do not apply. Still, over many years, a lot of that wonderful 50 cents on the dollar your employer may be contributing to your plan could get eaten back up in fees and transaction costs. Once it sees that, your employer might surprise you and “do the right thing” for its employees.

I noticed in doing yesterday’s column that the Lipper data we use in the Mutual Funds Cost Calculator was not completely accurate for “LAFFX,” the Lord Abbett fund we were analyzing. Lipper was showing “0%” as the fund’s turnover for the year, which didn’t seem right.

To check the numbers, I visited two sites I think you may find helpful.

One site you probably know is Morningstar. It’s got lots of good information on mutual funds, and other things, much of it free. Of course, it may allow the occasional error to slip in too — at the end of the day, humans get involved in some of this stuff — but like our own data provider, Lipper, it is widely relied upon.

A site you may not know is Personal Logic. It’s added all kinds of fun things since I last looked, from helping you choose a car to helping your kid decide where to go to college to deciding what city to move to . . . even what to do on a date. (It told me to take Charles to a bookstore.) But if you scroll past those choices (and past what pet to buy, what meal to cook, and so on), you’ll come to mutual funds. I used the “compare” option to look up yesterday’s fund, LAFFX, and found that turnover last year had actually been 56%.

It is for just this reason — and to let you change the assumptions that underlie the calculations of our Mutual Funds Cost Calculator — that we have added an important new subcalculator. You reach it from the “results page,” in the text beneath the third table, where we project future fund performance. We provide you an opportunity to change almost anything — and guidance in when and how you might want to.

I plugged in the 56% turnover figure and found that LAFFX was even less impressive than I suggested yesterday.

If you haven’t already, please register with us when you visit the Mutual Funds Cost Calculator so we can keep you abreast of enhancements as we make them. It’s completely free, and we don’t share your e-mail address with anyone.

Tomorrow: Iced Tea, Diet Chocolate Soda, A Brief English Lesson, and What To Do If Your 401(k) Offers Rotten Mutual Fund Choices

Ray D: “I just used your Mutual Funds Cost Calculator. I have $162,000 ($54,000 of it in accumulated gains) in LAFFX. Your table gives me an idea that switching to Vanguard tax-managed income/growth would be much wiser. So it seems that selling my position might be smart? I am in the 40% tax bracket Fed/state combined.”

Well, this is the $64,000 question. It’s much like the question of when it makes sense to refinance a mortgage to take advantage of lower interest rates. How do you balance the lower monthly payments against the one-time cost (and hassle) of refinancing? You can never know for sure, except with hindsight, because you don’t know how long you’ll own your home — or even where interest rates will be next month. (If they went down a quarter of a point, you’d have been better off waiting.)

When it comes to switching to a lower-cost mutual fund, the answer may be, if anything, less certain. But at least one side of the trade-off is pretty easy to estimate: the up-front cost of make the switch. In your case, given long-term gains of $54,000, you’d probably have to pay around $13,500 in tax (give or take), to sell your Lord Abbett Affiliated Fund Class A shares (symbol: LAFFX). I’m assuming the gain is all long-term and that your 40% ordinary-income tax bracket translates into about a 25% long-term gains rate.

(I’m also assuming you are not accidentally double-counting as taxable gains appreciation from reinvested dividends. You’ve already paid tax on that portion of the growth in the value of your holdings. This is a common mistake.)

(Note to novices: Speaking of common mistakes, some people think that when you switch from one fund to another within a fund family, and receive no actual cash, there’s no tax to pay. Sorry. Switching from one fund to another means selling the first fund and buying the second. And when you sell the first, unless it was sheltered from tax in an IRA or someplace, you owe tax on any gains.)

Of course, if it weren’t for taxes, I’d suggest you’d dump LAFFX for the Vanguard fund — or one like it — in a heartbeat. But since taxes are a factor, how long will it be before the likely improved performance exceeds this $13,500 hit?

First we have to make some assumptions on just how much better you might actually do in the lower-cost fund.

According to the Mutual Funds Cost Calculator, your Lord Abbett fund, symbol LAFFX, is a bit of a dog. Morningstar gives it four stars, which is great if you’re a general in the Army. But to begin with, LAFFX charges a 5.75% load. You likely paid several thousand dollars in commissions just for the privilege of buying this thing. You may just as well have burned that money. But that’s not relevant to your decision, because what’s gone is gone.

What’s relevant is the difference in ongoing costs. We show that you paid just over $5,000 last year in fees and taxes to own the fund. That’s $3,500 to $4,000 more than you would have paid with the four low-cost alternatives we display (one from Vanguard, two from Schwab, one from Strong).

So, all other things being equal, it would take three or four years before the $13,500 up-front cost in taxes were overtaken by your cost savings. (Over the next 30 years, you could come out hundreds of thousands of dollars ahead.)

But are all other things equal?

If — never mind the costs and taxes — LAFFX way outperformed the other funds we compare it to, then you might not care what the costs and taxes were. But, interestingly, at least last year, LAFFX was the hands-down loser of the five. Pre-tax it showed a 16.5% return, where the others ranged between 21% and nearly 24%. After-tax, LAFFX made 14% for you versus the 20.8% increase in wealth you would have had from the worst of the other four.

Might this be because LAFFX is a much more conservative fund? A laggard in up years but stellar in bad years? Probably not.

We don’t show “beta” in our calculator, but I looked it up, and for LAFFX it’s .87. A beta of 1 means that a fund is likely to go up or down about as much as the market. A beta of 2 means it’s a lot more volatile — if the market goes up or down, the fund is likely to go up or down twice as much, like a higher-strung theater-goer. (You, with your beta of one, laugh when something’s funny, sniffle when it’s sad. The guy in the seat ahead of you — with a beta of three — becomes hysterical.) A beta of just .5 means a fund is hard to move at all (a slight squint as Jackie Mason riffs; a furrowed brow as Juliet sees Romeo and dies). So LAFFX, at .87, was a little stodgier, but basically pretty much like the market.

Why would anyone give up 5.75% and then extra expenses and taxes for a stodgy fund?

(I can rag on Ray this way, because apparently LAFFX was not his idea. He inherited the shares. His benefactor was wise to save/invest money, generous to leave some to Ray, but no genius for choosing this fund.)

In short, the decision of whether to switch depends on several things. First, the cost of switching — that part we know — but then how much better you’d do in the new fund. Maddeningly, it is very hard to find funds that will do meaningfully better than average over the years. (Some years, yes; but not, cumulatively, over the years.)

So it often does make sense to switch to a lower-cost fund — and the longer you plan to hold the new fund, the more sense it makes. If Ray planned to use this money to buy a house in two years, he shouldn’t switch. If he’s likely to just let it grow for 30 years and then begin gradually drawing on it for retirement, he should.

There’s also the issue of tax bracket. If for some reason Ray were soon to be in a much lower bracket, he might wait. The tax on his $54,000 gain would be lower (although for the long-term gains rate to be appreciably lower he’d almost have to be starving); and the cost differential between the funds would be lower, because a lot of that difference this past year, and possibly going forward, is in the higher tax impact from LAFFX.

If Ray believed Congress were soon going to abolish or greatly reduce the capital gains tax, that would be another reason to wait.

So there are no guarantees what course of action will be ideal. But for most people in high-cost funds, switching to a low-cost fund makes almost as much sense as having bought a low-cost fund in the first place. (If you’ve been buying shares in a high-cost fund all along, it could make sense for you to sell the shares for which you paid the highest price, and on which you have a relatively low taxable gain; but to keep the shares you bought way back when, at a tiny fraction of today’s value.) I hope the Mutual Funds Cost Calculator helps you to think these things through. If it did prompt you to make a switch that did leave you hundreds of thousands of dollars ahead 30 years from now — well, wouldn’t we have something to crow about?

Tomorrow: Why not all our data may be right — and how to check

Dr. Steven Rubin: “Okay, okay, so 1600 Penn Ave may not be so tough, especially for a certain underpaid treasurer of the occupant’s political party. But I’ll bet that, unless you were watching by poolside, you checked your pockets for loose change when Regis asked on which coin does the head face to the right (which was the only question I saw while channel-surfing)!”

This refers to my September 8 comment on the ABC TV hit show (now in hiatus) “Do You Want to be a Millionaire?” and to the $100 question about what famous building is located at 1600 Pennsylvania Avenue in Washington (a-the White House, b-the Mexican Embassy, etc.).

Well, I’m first to admit the show IS good fun, and that there are lots of questions I would miss — although fewer now that I have become almost instantly hip, by my very recent exposure to the remarkable Wyclef Jean. In one night I learned who George Clinton is (not the long-deceased governor of New York, but one cool funky jazz dude with hair from another planet); who Sheila E is (a) Prince’s one-time drummer, now a very cool drummer of her own; (b) the woman who lost the last several letters of her last name in a freak chainsaw accident; (c) the White House; who Naomi Campbell is (Charles just rolled his eyes and explained that she is “only the hottest model out there after maybe Christy“); who Bono is (not the late sunny congressman, but the original U2 pilot) . . . and more.

So I would no longer miss all the pop culture questions.

But Dr. Rubin obviously did not stay tuned long enough to understand how easy that question would have been. When unsure, “Do You Want to be a Millionaire?” allows you a limited number of “lifelines” — including “Call a Friend” and “Ask the Audience.” So assuming you didn’t have change in your pocket — or a penny in your loafer (it’s the penny) — you could just ask someone who did. I tell you, this is not a tough way to make $32,000.

Emmett Redd: “Usually, we patronize the companies we own stock in so they can make more profit and our wealth goes up. But David Lazar (9-9-99) might do better not to patronize Mirage after he buys its stock because he is, he says, “a successful gambler.” His successful gambling would (however minutely) reduce the profitability of Mirage. This is quite a quandary, if you ask me.”

Yes. David should buy Mirage stock when he’s feeling lucky, but only gamble there when he’s feeling self-destructive.

John Reade: “Holy mackeral, your new web site is amazing. Like a lot of people, I’m freaking out at the cost of my mutual funds, now that I see the full impact. Do you have any simple advice on when to get out of a mutual fund? I realize the front-end loads have already come and gone and that back-end loads will be paid when I leave. Just wondering what other penalties/taxes may be incurred when I bail out of one mutual fund and go into another.”

Holy mackerel indeed. (And when was the last time you saw mackerel on the menu, anyway?) The front-end load is a sunk cost, and so shouldn’t figure into your decision. (Easier said than coped with psychologically, especially if you’ve only recently paid it.) The surrender fee, if there is one, is another matter. Most funds don’t charge them, but some certainly do. With many of those, the surrender fee scales down to zero after a few years, which gives you a (small) incentive to wait.

The big disincentive to switching is whatever capital gains tax you’d have to pay on the appreciation you’d realize. (In a tax-sheltered account, this would not be an issue.)

More on this Monday.

(Please note that I’ve added a permanent link to the Mutual Fund Cost Calculator, up there in the top left “link” area. I am incredibly proud of this, because it was one in the morning and I didn’t want to wake my web master, so I went into the html code and figured out how to do it myself. This is why it probably appears upside down on your screen, or accidentally links to the Naomi Campbell photos.)