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What Are The Best Stocks To Invest In For Retirement? Part III

What Are The Best Stocks To Invest In For Retirement? Part III

In our previous articles, we discussed the top three rules to follow when selecting individual stocks and touched on how this approach is not always the best option for all investors—with low-cost ETFs and mutual funds sometimes a better fit. However, for those who are specifically looking to reduce their tax consequences and have enough money to do so, individual stock management is the way to go. Some specific rules we reviewed previously include to (No. 1) avoid overlapping, (No. 2) include a high active share count in your strategy, and (No. 3) engage in active management. With these behind us, let’s now move on to Rule No. 4: avoid co-mingling.

Rather than employing co-mingled fund products—especially inactive strategies—you want to use separately managed accounts where possible. Now, as we’ve discussed before, active strategies does not imply “timing” the market. Instead, it means researching stocks and companies and buying those that look most profitable. It means performing intensive research on a small sect of the market, say large-cap value or small-cap growth, and then buying and selling companies according to how sound they look based on research team parameters. 

When we say to avoid co-mingling (Rule No. 4), we mean the following: don’t put money into your online brokerage account —whether Merrill Lynch, Charles Schwab, Fidelity, Vanguard, etc.—and then ship that money off to co-mingle with other investments within a mutual fund. But why? Perhaps you’re reading this article and thinking, “Well, that doesn’t matter that much. That doesn’t hurt me.” But let’s look at the implications of pooling your money with that from other investors inside of a mutual fund or ETF. Before discussing how your fund manager directly manages a portfolio of stocks in a mutual fund, let’s examine how this works inside of separately managed account.

In this case, it’s a little bit different. Boiled down to the basics, your money goes into your brokerage account, stays there, and you buy individual stocks. Then, the fund manager manages your stocks and bonds directly inside your account. This is different than sending your money to a mutual fund company where it’s co-mingled with other investments. Now, let’s dive into 12 specific reasons why you want to avoid co-mingling by using separately managed accounts for stocks and bonds versus relying on mutual funds.

Reason No. 1 is that separately managed accounts allow you to own stocks and bonds directly. Reason No. 2? Cash and assets always stay in your own account, as opposed to mutual fund managers choosing to sell varied stocks and hold more cash than what you had planned. As such, you’ll always know exactly how much you have in cash and the amount invested in stocks. Reason No. 3 is that this approach provides you with an individual cost basis for every single stock and bond you own (rather than one for only your individual mutual funds or ETFs), and No. 4, you know exactly which investments you own in real time—which is very important for avoiding specific stocks. It’s impossible to know when a mutual fund or ETF sells one particular stock or bond and buys another; however, a separately managed account provides access to this information, which is important to many investors.

Reason No. 5 is that the decisions of other investors won’t impact your performance. Let’s consider a specific scenario. Perhaps a mutual fund investor decides to buy a second home for $1.2 million, and since they want to pay cash, liquidate their funds accordingly. Therefore, the mutual fund company is forced to sell shares of the underlying securities—whether stocks or bonds—to free up the cash for that particular investor. But hey! You didn’t agree to that. Yet, these types of sales within mutual funds and ETFs trigger taxable events. Even if they’re held inside of IRAs, the mutual fund or ETF must pay taxes on these gains to the IRS. There are also related trading costs. So now, based on someone else’s decision, you are forced to pay extra taxes (oftentimes short-term gain taxes) and incur unwanted trading costs.

Moving along with our list, Reason No. 6 is that you only pay taxes on your own gain or loss realization, meaning that, again, you won’t have to do so when another party decides to pull out money. While the mutual fund is responsible for paying these taxes, it will impact your mutual fund performance nonetheless. Reason No. 7 is that you only pay costs and fees that you authorize, mimicking exactly what we just discussed. If you want to sell within your own account, you’ll be inherently privy to the taxes, costs, and fees triggered by the sale. As such, it’s your decision to make that trigger call, whereas this control is lacking within a mutual fund or ETF.

Reason No. 8 is that you’re the sole party holding your cash in assets, which we’ve discussed previously. In this way, you avoid putting money into a mutual fund that eventually decides to have 5% or 10% in cash. Perhaps you also have cash in the account as well, meaning you wind up lacking knowledge about that exact amount at any given time. No. 9 is that you can customize what you own with a separately managed account, and No. 10, harvest capital gains or losses to the penny. This is one of my favorite reasons to avoid co-mingling because you can control the taxes; and for investors in higher tax brackets or even those in the 20s, say 22% or 24% under our current bracket system, they’ll still save money in the long run. Some stocks will always go down even in bull markets, which you can sell at the end of the year to help offset the gains of others.

Rounding out our list, Reason No. 11 is that the average number of mutual fund holdings is over 400—as opposed to around 75 in separately managed accounts—and No. 12 is the average annual turnover. This, again, is one of the most important advantages. A separately managed account only has a 30% turnover, meaning that if you own 100 stocks, only 30 are sold and replaced per year. Yet, if you own, say, 400 mutual fund holdings with 100% turnover, this means 400 stocks or bonds will be sold each and every year—a huge difference! Considering the example above, 30% of 75 holdings means that an average of 22 stocks will be sold per year within your separately managed account strategy versus 400 in a mutual fund: generating a tremendous amount of transaction costs and more short-term capital gains.

Given the information shared above, you’re now well aware of the advantages and reasons why institutions—and our investors—use separately managed accounts rather than mutual funds. Even the best managers struggle to bring up their mutual fund performance to mimic that of separately managed funds. Polen Capital is a great example of a money manager with a proven long-term track record with separately managed accounts, especially given a study performed to compare this performance against that of their mutual fund.

This research reflects that the Polen SMA had a fee of 0.65%, their disclosed expenses, while their mutual fund had a disclosed expense of 1.25%. [KM1] So right off the bat, we know the mutual fund is 0.6% more per year than the separately managed account strategy. What we don’t know are undisclosed mutual fund expenses, which is the nature of the beast. The average SMA five-year return during this bull market was 146.8%, whereas the mutual fund returned 130.7%: a difference of 16.1%.

Given a $100,000 investment over five years, this translates to a little over $16,000 earned by employing a separately managed account versus a mutual fund which, again, speaks to the disadvantage of co-mingling—even while using the same exact strategy. The separately managed account strategy averaged 19.8% during this particular five-year period (which was obviously a raging bull, given these numbers), while the mutual fund was 18.2%: a 1.6% difference per year. That right there could easily pay your comprehensive or holistic financial planner, further supporting a switch to a separately managed account and enabling creative investments that stretch beyond just the large-cap stock market.

In 2009, The Wall Street Journal compared all mutual fund equity strategies against all corresponding separately managed account strategies for the calendar year of 2008. Now, of course, 2008 featured the monumental crash we’re all so very familiar with. The US Stock Market, as measured by the S&P 500, decreased by about 37% during that time. Interestingly, it’s very important to know how strategies perform during down markets and crashes because big losses hurt long-term returns to a larger degree than big gains in fact help them. So, as we examine the 2008 large-cap core for separately managed accounts, these exhibited an average decrease of about 34.8% whereas mutual funds declined 38%: a 3% difference.

Another example is midcap. For separately managed accounts, these dropped about 37% whereas with mutual funds, on average, midcap stocks declined about 39.7%—meaning that using the former strategy resulted in a 2.6% advantage. In yet another example, the 2008 international large-cap core reflected a 42.3% average decline for separately managed accounts. The average mutual fund? Yep, it posted a 44.1% decrease, reflecting a difference of 1.8%. Beyond just taking this extra money to enjoy more comprehensive financial planning services, employing separately managed accounts can also provide you with the peace of mind that you can outlive their money regardless of stock market performance. 

Now, let’s touch on tax loss harvesting a bit. In 2017, even though the S&P 500 went up 21.9%, 80/500 stocks were still negative that year. As such, if you owned the S&P 500 index, you received a 1099 tax form with zero control of your taxable gain. However, in the event that you had a separately managed account as well as those 500 stocks, you could have chosen to sell the “losers” to offset the gains—in turn reducing your tax liability in that particular year. This is an example of tax loss harvesting inside the S&P 500 and yet another difference between a mutual fund and separately managed account with the same exact 500 stocks in a given year. Truly, one of the most important taxable account activities is to sell the “losers” against the “winners” (and those with gains each year) to keep the long-term tax consequences extremely low—particularly for a stock strategy.

If you would like to find out what it would look like to have your investments in separately managed accounts rather than mutual funds or ETFs, I would be happy to offer you a free no-obligation audit or second opinion on your current portfolio. Just click on the link here: https://calendly.com/thomascloud/retirement-ready-success-call to set up a 20-minute chat, which we refer to as our retirement-ready success call. We can go over where you are now, where you want to be, and I’ll share successful strategies and tips I employ with my clients to help them achieve financial independence regardless of what the governments or markets do.

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