The world of investing is riddled with decisions that have no clear cut answers.  Most investment decisions are made with less than perfect information, and most decisions include a lot of estimates. This uncertainty, or risk, is usually a primary factor that helps investors to calculate an expected return from an investment.  But aside from the risk inherent in a security or asset class, an investor must also choose the investment vehicle, which typically also affects the total return.

Once an investor makes a decision to invest into a specific strategy, they must then decide on the vehicle or method to implement that investment decision.  With an investment in equities, for example, an investor can choose to invest directly into a portfolio of stocks using a separate account, or choose a mutual fund, an ETF(exchange traded fund), or an option/derivative.  All of these methods for investing into equities are implemented in different ways, they will yield different returns, have different risks, different tax consequences and are typically invested into by different specialists.  In this article, I’d like to discuss the benefits of investing into stocks using a separate account over a mutual fund or ETF.

Here are some risks and concerns of investing using a Mutual Fund as the vehicle for investing into Equities.  Equities, or stocks, when sold will typically yield either a capital gain or loss which will accompany the transaction.  A risk or concern with an investment into a stock, will be related to the taxable effect of this investment over time.  

Concerns when owning a mutual fund or ETF:

  1. Taxable or Non-Taxable Account - First, as an investor considering a mutual fund,  you will want to take into consideration the tax status of your investment portfolio.
  2. Holding period of the investment - How long do you plan on holding this investment, and is there a scenario where the funds would need to be accessed earlier than expected?  The holding period of the investment will be used in a calculation of expected short term or long term capital gains.
  3. Fund Fees - Mutual fund fees are often well in excess of ETF fees so they are disadvantaged in this way over ETFs.  ETFs have a major disadvantage over mutual funds in that they are usually passively managed, meaning all of the poorly performing stocks are lumped in with the better performing stocks.  Because mutual funds are commingled the management expense ratios (MERs) need to taken into consideration.
  4. Separate account fees - If you choose to invest using a  separately managed account, there will be fees associated with the management of this account.  These fees can be similar to a mutual fund, or in excess of the mutual fund depending on the manager.  Below we will talk about some of the benefits of having a separately managed account instead of a mutual fund or ETF.  This analysis will hopefully help you to decide which investment vehicle is best for your situation.
  5. Built in gains/losses - At the time that you buy into a mutual fund, you are buying into existing gains/losses inherent in the fund.  What this means is that you will be sharing in the gains/losses that earlier investors have benefited from.  And, in a taxable account, if you buy into a fund and simply hold that fund through year end, you may get a tax bill because the overall fund is making buys and/or sells.   If you must own a mutual fund, you are better off doing this in a non-taxable account.

Now let’s discuss the benefits of having a separate account for investing into equities:

  1. Buy/Sell Decisions - Most importantly, an investor can tailor their risk tolerance and work with their account manager to stay within their objectives and constraints.  Tailoring your risk tolerance will allow you to create guidelines and boundaries for the portfolio manager to follow.
  2. Tax Consequences - More control over the timing of the taxable consequences of the account.  One of the large downsides of buying into a mutual fund, is that you are buying into any existing gains or losses that the portfolio may have.  This means that as a mutual fund has capital inflows and outflows, taxable events are occurring that may affect your account.  Taxable events that can be passed on to you as a investor.  One way to avoid these taxable events of a mutual fund, is to own them in a non-taxable account like an IRA.  Depending on your situation, not owning a mutual fund or ETF may be the best decision.
  3. Transaction Costs - You can control the transaction costs by limiting the buys/sells.  When you own a separately managed account, the amount of turnover in assets can be controlled to limit the added expense of transaction costs.  In a shared account like a mutual fund or ETF, the transaction costs can be substantially higher and this cost is passed onto the investors.
  4. Taxable Gains/Losses - The timing of taxable events can be controlled by the investment advisor.  Commingled accounts like mutual funds and ETFs don’t take into consideration any individual, they are managing the assets for the benefit of the entire fund.  And so, the timing of you buying into the fund or selling are not relevant to their investment decisions.  When you have a separate account, the gains and losses can either be managed and matched against long term and short term transactions to minimize the taxable effect to the account holder.  The investments can be held on to until they are considered long term, and thus limiting the tax liability of the account.
  5. Your investment strategy run by a professional - A common problem that individual investors encounter, is making the wrong decision at the wrong time. It’s often difficult for an individual investor to find the time necessary to analyze the markets and potential investment decisions, which can make hiring a professional a wise choice.  Whether that is at a separate account, a mutual fund, or an ETF a professional can help you to navigate the ups and downs of the markets.  Any of these options are often better choices than running your investments on your own.  With that said, when you have a professional managing a separate account, you will have the opportunity to discuss objectives and co-create a custom strategy for your account.  The investment manager will take your preferences and help you to mold this into an investment strategy that is agreed upon by all parties.  Once this is done, you as the investor should feel more comfortable that your investment targets will be prioritized within the confines of your objectives and constraints.

Choosing a mutual fund, ETF, or separate account is usually not a quick, simple or easy choice for an investor.  Investors often get overwhelmed with making strategy decisions regarding the investment vehicle that is best for their situation.   At Robert Bender & Associates, we specialize in managing separate accounts for investors because we feel the long term benefits are greater than investing in an ETF or mutual fund.  Before choosing to invest in a fund, be sure to take all factors into consideration by comparing management expenses, total returns  and potential tax consequences.