When to Dump that Expensive Investment Fund

Mistakes? We’ve all made a few. (OK, many). 

But as financial advisors, we’re also in the business of helping clients correct past errors, and that includes an analysis of when to dump the more expensive, less-diversified mutual funds and ETFs in order to develop a more diversified ultra-low-cost portfolio. Now, that doesn’t mean blindly selling everything. Advisors don’t want to go tell the client something like: “Don’t worry about the $200,000 income tax bill.”  

Instead, frame the decisions on which funds to sell as a choice between ripping the bandage off or having a slow bleed. Sometimes the decision is a no-brainer, while other times a fair amount of analysis is required. And we must take into account the client’s emotional tendencies. First, we all hate to pay taxes. So the starting point with the client is to keep the existing investments that would have a large tax bill if sold. Second, inertia is (in my opinion) the most powerful force in the universe. 

When you combine the complexities of tax-law with the even greater complexities of human behavior, the task of jettisoning past investment mistakes can sometimes feel more complicated than rocket science. When deciding which funds to sell, however, start with some low-hanging fruit, and then discuss how to analyze closer calls. 

Dump the Dogs

First, most clients have turned on dividend reinvestments for all of their funds (good and bad). So the first no-brainer is to stop buying more of that awful fund by turning off dividend and capital gain reinvestments. For example, I’m guilty of that one myself. In early 1990, I bought the Dreyfus S&P 500 index fund (PEOPX), now called the BNY Mellon S&P 500 Index fund, in my taxable account. With an annual expense ratio today of 0.50%, it has no chance of besting a fund like the Vanguard S&P 500 (VOO) with a 0.03% annual expense ratio. I finally stopped buying more and turned all reinvestments off. Even if this weren’t an index fund, the higher the expense ratio, the lower the expected return vs. the low-cost alternative.

The next no-brainer is if the fund is held in a tax-advantaged account, such as traditional or Roth 401(k)s or IRAs. There are no taxable gains to be paid to dump the dog. If clients are making charitable donations, they can donate the fund with high gains to a charity or donor-advised fund.

Next, I look at whether the investment is even appropriate for the portfolio. For example, the client may hold a triple-levered, inverse index fund with a gain. Tell the client they got lucky and to get out and pay the taxes.

The final place to start is understanding the tax bill from a sale. If it’s a bond fund, there can be little or no tax consequence. Or the client may have a tax-loss carryforward to offset some or all of the gain. With such a strong bull stock market, it’s unlikely the client has stock funds with losses. But, if the client is retired, they could be in the zero percent federal long-term capital gains rate ($96,700 or less after factoring in, at a minimum, the standard deduction) for those married filing jointly. One must also consider possible state income taxes.

All Things Are Rarely Equal

OK, after the low-hanging fruit has been picked, the first analysis is to compare the value of deferring taxes to the lower expected return from the higher expense ratio. Say the client has $100,000 in a fund with an extra 0.47% annual expense (versus a low-cost index fund) and an unrealized long-term gain of $20,000. Let’s say the client is at the 20% marginal tax rate, including state, so the client would pay $4,000 in taxes. Deferring these taxes is like having an interest-free loan with some risk that tax rates may rise. So, at a 5% interest rate, that’s like getting a $200 annual benefit. I compare that to the extra $470 annual expenses of this fund ($100,000 x 0.47%) and conclude it’s better to sell.

If the fund had an $80,000 gain, then the math would work, comparing the tax-bill of $16,000 (80,000 x 20%) and the value of the deferral would be $800 annually. All things being equal, I’d recommend keeping the fund with no dividend reinvestments.

But all things are rarely equal. Many funds (including PEOPX) pass through gains when the fund sells the holdings. Either the fund actively trades, or perhaps it’s in what I call a death spiral. Because the fund underperforms, many investors cash out of the fund, causing the fund to sell some holdings at a gain. This extra tax bill causes more investors to want to get out, and the spiral continues. Unlike mutual funds, ETFs have a more tax-efficient creation and redemption methodology so they rarely pass through gains. 

So far, we’ve assumed the client may be deferring the capital gains tax, but sometimes they can completely avoid the capital gains tax if they never sell and their heirs get the step-up basis when they pass away. If the holding is in an irrevocable trust, there is likely no step-up benefit, but if held personally or within a revocable trust, they likely will qualify. So, in situations where the client is planning to pass on some holdings to heirs, we must look at the life expectancy and years of paying the higher fees compared to the benefit of avoiding the capital gains tax altogether.

Doesn’t Have to Be Rocket Science

Often, large sales can push the client into the 20% marginal federal capital gains rate and the 3.8% investment income tax rate. They may also live in a state with high taxes. So selling some each year for a few years may be the solution. Or maybe the client is about to retire and move from a high tax state to a state that has no income taxes. 

Often the solution isn’t binary as one could sell some, but not all, of that fund. This has two benefits. First, it allows one to pick the specific lots to sell those with the smallest tax consequences. Never use an automated method (like FIFO or even Vanguard’s MinTax). The second benefit is emotional, to minimize regret. If the fund does poorly, they can feel great about selling some. If it does well, they can blame the advisor for the recommendation and be happy they kept half. I’m dead serious about this, as it provides a mental option for the client. I’ve always said investing was simple, but never said taxes were. In addition, neither advisors nor clients are logical, rational beings. We are feeling animals. 

Tax-law and human behavior are complicated, but there’s a method to mitigating past investment mistakes, so it doesn’t have to be rocket science.