There is a passage in Moby Dick where Ishmael reflects on the sight from the masthead. He could have been speaking to the world of investing in mutual funds as much as he was discussing the meditative sights below his perch. Melville writes that from that vantage “you stand, a hundred feet above the silent decks, as if the masts were gigantic stilts, while beneath you and between your legs, as it were, swim the hugest monsters of the sea… The tranced ship indolently rolls; the drowsy trade winds blow; everything resolves you into langour.” And from our desks we watch our investments swim below us, our mutual funds existing in a world of murky depth, and our distance providing perspective on how well they are doing and giving us, at the same time, no perspective at all.
Melville writes a cautionary tale with a well-known outcome. And as we enter the fourth quarter of what is turning out to be one of the more volatile years for investors, where advice on what to do has mostly proved wrong (move to cash, they said to avoid, as Melville writes “the universal cannibalism of the sea”) and to coin a nautical term “stay the course” has proved profitable. We set sail and hope for the best and yet are wary at every change in the investment weather while we worry about what swims beneath the surface.
Such events leave us wanting to gain some control over where we are and what we determined as the course we’ve set. No one enters the ocean of investment choices without wondering if the plot we have set in motion will be the right one. One of the monsters of the deep however may breach the surface of your calm sea and take back the adventure. This will happen if you are not careful. But even care may not help.
It is often recommended that you watch over your investments, periodically rebalancing and adjusting your portfolio to follow the course you may have set. You can, as many do in the final months of the year, increase our contributions to your 401(k)s and IRAs to grab the tax advantage. But that act might not turn out as expected; particularly when the funds you invest in may also be considering a chart change as well.
You can’t invest without considering the tax consequences. You invest, often in a pre-tax way to capitalize on the advantage your plan offers. And when you invest otherwise, you sell what you own to grab the gains you have made and if you are tax-savvy, sell the losers in order to offset those profits. But what if you have no losers? What if the year was good enough to book the profits? What if you are a mutual fund manager and those profits need to be sold despite your best efforts, to satisfy the redemption of less confident investors who may have heard the siren song of another investment opportunity?
Several things you need to consider in the coming months as you contemplate what to do with the investments you own. When Melville wrote: “We cannot live only for ourselves. A thousand fibers connect us with our fellow men; and among those fibers, as sympathetic threads, our actions run as causes, and they come back to us as effects” he was not writing about mutual fund investors and the thousand fibers that this sort of investment connects us to others like us. Yet mutual fund investors simply can’t and in many instances, won’t consider the group as a whole when making investment decisions – and they shouldn’t. But what you do and how the fund manager reacts matters.
The fourth quarter as I mentioned is often the time when you consider changing your investment balance. And this consideration is often recommended. But the fourth quarter may very well be the worst time to do what would seem to be the right thing to do. The tax implications of selling shares in one fund and buying those of another may give you the very thing you don’t want: capital gains without the capital gain.
Investors looking to purchase shares in another fund might find the fund manager has the same motive: rebalancing. had you been in that fund for the whole year or longer, the capital gains is welcome. Enter the fund in the weeks prior to this event, and you get all of the taxable downside and none of the profit.
It isn’t s if this comes without a warning. A fund’s website will often estimate these distributions and your research (you do research right?) should give you reason to hesitate. What is often less clear, is the fund manager’s reason when it is due to redemptions. Redemptions in mutual funds trigger a series of events. The exiting shareholder must be paid and to pay them, something must be sold. When the redemptions are small, the event is almost unnoticeable. When the exits are packed however, the selling impacts the remaining investors. If it was good year, then gains are sold.
According to Christine Benz, Morningstar’s director of personal finance “The strong market rebound since early 2009 means that many funds now have more gains than losses on their books: In fact, fully half of the equity mutual funds in our database have positive potential capital gains exposure, meaning that they have gains on their books that they haven’t yet paid out to shareholders, and more than 200 stock funds have potential capital gains exposure of more than 50%.”
While a domestic mutual fund may have large profits that may or may not be realized before years end, some emerging markets and International funds will need to satisfy exiting shareholders in greater numbers than in years past. Many of the funds concentrated in areas like China, Brazil or even Latin America are on the small side. The smaller the fund, the greater the impact of an investor exodus. With Europe hanging in the balance, many small and mid-cap funds may find their ship sailing in choppier waters than the previous three quarters.
Of course, if you need to rebalance, do so. But do so with a word of caution. If you can wait, that would be wise and even prudent. But do your homework well in advance of any sudden changes. While you can’t time markets, you can time these distributions. And failing to do so could cost you dearly. As Melville points out: “Ignorance is the parent of fear…”