Mutual Funds Research Newsletter
http://funds-newsletter.com
Copyright 2008 Tom Madell, PhD, Publisher
Dec. 2008
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How Taking Action Soon Will Allow You to Gain from the Crisis
Fed Funds Rate to Zero? Why it Matters
For many years, one of my biggest concerns regarding my fund investments has been having to pay a whole lot of taxes every year in the form of capital gains distributions. Even in a bad year for stock funds such as this one, many funds will be passing on such distributions with the lion's share coming in December.
In past years, it has been hard to take the kinds of actions that might reduce these yearly tax bills, or even better still, to cut down on the taxes that will be due when you eventually sell a fund in the future, assuming, of course, that you sell at a profit.
But given the current bear market, one of the rare bright spots is that it presents many investors with a golden opportunity to significantly reduce their tax burdens, not only for 2008, but for as far out into the future as they continue to own funds.
On the surface, this relentless bear market might seem utterly frustrating in that taking any action, either selling or buying, looks imprudent. But, if you have a long-term perspective, there are now some great opportunities to improve your situation, while hoping for the return to better days. It is now also far less burdensome, tax-wise, to exchange out of funds you think are no longer your best choices and into funds you think will serve you better in the future, performance-wise.
This article focuses on how you can take advantage of depressed stock fund prices to unsaddle yourself from current positions that otherwise will lead to high tax payments, or perhaps allow you to substitute better performing funds, without necessarily increasing your stock allocations in the midst of an on-going bear market. What we will discuss will go way beyond what you may have already heard regarding "harvesting tax losses" to offset gains and/or current income. Instead, we will focus on
Note: Since taxes as such are not my field, the discussion below will give you enough information to further explore taking the kinds of actions that should save on taxes. You may need to do some additional research to better understand how these recommendations will apply more specifically to your own particular situation.
Especially in recent years, it has been easy to not be very troubled by capital gains, both the regular ones that funds themselves post to your account mainly every December, and those that you yourself incur when you sell a fund at a gain. While no one likes taxes, thanks to the Bush tax cuts, a maximum long-term capital gains rate of 15% seemed to be a relatively small price to pay as compared to the taxes most people must pay on ordinary income, usually around double that amount.
But now that your stock portfolio has likely been losing rather than gaining money, it seems like adding insult to injury that we must often still incur some hefty taxes due. For example, I recently discovered that one of my funds was distributing about 12% of my account value as capital gains, meaning that for every thousand dollars invested in the fund, I will have to pay taxes on an additional $120 on or before April 15th, 2009. While very few distributions will likely be that extreme, you may decide that any large tax bills at all are not worth the overall return the fund has been giving you, year after year.
If big capital gains distributions have been visible on your prior tax returns, there is likely still time to deal with this for 2008. And even if you don't discover these embedded tax hits until early next year, you can still reduce them for future tax years. But acting during the current bear market (and better still, early this month) presents an excellent opportunity to lower the total amount of taxes you incur as a mutual fund investor. Lower taxes down through the years, of course, increases your total after-tax return.
To both avoid this December's taxable distributions and reposition yourself so that you won't be hit again in the future, follow this plan (or if you work with an advisor, ask him or her to implement it for you):
In bull market years, selling a fund at a profit will likely incur a capital gain you must pay. But in today's market, selling will likely get you a loss instead which will reduce your 2008 taxes. But really, the main purpose of making the switch is for future years. If you go into an index fund, or perhaps a fund that does less trading, or maybe even a "tax-managed fund" (such as available at Vanguard) or an exchange-traded fund (ETF), your future taxes should be much less as well.
How can you be sure of selling before the ex-dividend date? You will need to find out when it is from the fund company (many companies post the date on their web site). And how can you be sure that the new fund will be more tax-efficient? One way is to check on the morningstar.com web page. After entering the fund symbol in the box "Quotes", click on "Tax Analysis". Look for the "% Rank in Category" number, ranging from 1 to 100. The lower the number, the more tax-efficient the fund. For example, Fidelity Magellan (FMAGX) is not very tax-efficient at all as compared to other Large Growth funds with a 5 year rank of 95, meaning the 95% of other such funds are more tax-efficient. Our recommended Growth fund has been Vanguard Growth Index with a 5 yr. rank of 34.
To possibly minimize your 2008 taxes even further, wait to buy the new fund until after it too has made its distribution. That way, you won't be subject to its distribution either.
As time goes by, you may realize that a given fund, long held within your portfolio, while having achieved gains, hasn't performed nearly as well as an alternative similar fund. Or, you may have come to the conclusion that its fund category is not going to do nearly as well in the future as it has in the past.
Let's use a real estate (ie REIT) fund as an example, although many other fund categories could apply as well. Perhaps you might still have some gains if you have held such a fund since the start of 2000 but you now realize that the category has likely lost its edge. Prior to just a few months ago, to sell such a fund, you would have had to subject yourself to capital gains resulting from the appreciation of the fund's price. But now, with that gain highly eroded or even a capital loss, it is much easier tax-wise to sell that fund.
Once again, I would not typically recommend selling such a fund - a REIT fund should be considered as a type of stock fund - and placing the proceeds in an entirely different asset category such as bonds or cash. While a capital loss may make sense for tax purposes, it is still a loss and means that you are likely selling while prices are low. So, a better idea is to exchange the proceeds into a another type of stock fund, or perhaps even to a better performing REIT fund that you may have become aware of.
Continuing with the real estate fund example, suppose you own Vanguard REIT (VGSIX). Over the last 10 years, the ann. total return has been good: +8.25% thru 10-31. But, over the past year, the performance has been a miserable -58.9% thru 12-1. Since REITs are now out-of-favor, it might be wise to switch into a different stock fund category that would appear to be a safer choice, such as Large Blend. Or, you might opt to switch into another real estate fund that has an even better track record, such as the CGM Realty Fund (CGMRX). It is the #1 performing such fund and has a 10 yr ann. return of 17.70% thru 10-31, although the 1 yr. return is even a little worse than VGSIX.
Thus, you can likely use the current crisis to upgrade your portfolio without taking a capital gains hit. (CGMRX also happens to be a highly tax-efficient fund, with a Percent Rank in Category on Morningstar of 1, which is better than VGSIX's 34.)
Also as a side-effect of the bear market, many excellent funds that have been closed for a number of years may have now re-opened. So if you have wanted to upgrade your portfolio by including a certain previously closed fund, check to see if the fund has now reopened. For example, both the Vanguard Health Care and Explorer Funds recently reopened, although the minimum investment for the Health Care Fund is high - $25,000.
Today's maximum capital gains rate of 15% was instituted during George W. Bush's first term. It is an historically low rate, as least as compared to the rates in effect prior to it. As things stand now, this rate is set to expire at the end of 2010 and revert to a maximum of 20%.
In spite of recent hints to the contrary, there can be no guarantee that these rates won't be raised before 2011 or hiked even higher than the pre-Bush 20%, as one way of dealing with our already huge budget deficits or for offsetting the cost of new programs envisioned by the incoming Administration. Therefore, if you still have funds for which you have made significant capital gains, and if you believe that capital gains taxes for your income level could be going up, it might make sense to sell some or all of these funds while, as above, still choosing to maintain your allocation to the same fund categories.
But since the purpose is essentially to ensure capturing of capital gains taxes at 15%, be sure not to just sell and immediately buy back the same fund within 30 days: This is not allowed by the IRS. You can, however, immediately buy back a different fund that is quite similar to the fund you sold. For example, if you sell a fund such as Vanguard Small Cap Index, you would have no problem doing if you exchange it for the Vanguard Tax-Managed Small-Cap Fund.
If you have an employee-based tax-deferred account, such as an IRA, 401(k), a tax-sheltered annuity, or 457(b) plan, you may have thought about doing a Roth IRA conversion but been frustrated since the rules only allow you to do it if your total income (single or married) is less than $100,000. While this remains true this year and next (but no longer beginning in 2010), if your income is likely to be somewhat over this amount in 2008, you may still be able to do the conversion thanks to the bear market. Here's how:
Say your expected income for 2008 is about $110,000 including your taxable fund distributions. Normally, there would be no way that you could do the conversion. But as a result of the current severity of the bear market, most fund investors taxable portfolios probably have many positions that represent losses. By taking these losses, you may be able to bring your taxable income below $100,000. Take this simple example.
If your adjusted income is roughly $95,000 and you normally get about about $15,000 in capital gain distributions and dividends from funds, here's what you could do if your taxable portfolio contains significant losses:
While it may take a little work, you may now be able to qualify for doing a Roth IRA conversion, even if you weren't going to be able to do so before. And needless to say, if your adjusted income is below $100,000 even without doing this little trick, you should seriously consider doing the conversion.
While doing the conversion requires you to pay tax on the gains you made within the original tax-deferred account at today's ordinary income rates, you will never again have to pay any further taxes on the Roth IRA capital gains or dividends. And you can convert a greater percentage of your IRA now while you IRA balance is depressed due to the bear market. It may also prove to be wise to do the conversion this year if the tax rates for ordinary income, like capital gains taxes, wind up going significantly higher in subsequent years. All this is on top of the fact that by making the conversion while stock prices have been seriously dented, you stand to make the most out these funds in the future when they inevitably return to more normal levels, and none of the easily conceivable 100% or more gains will be taxable.
Looking ahead, for investors it is important to project whether we are headed to a 50 basis point (0.50%) Federal Funds (fed-funds) rate this month and whether the rate will fall to zero in the coming year. The current 1% rate was set by the Federal Reserve (Fed) in October. My view is that the likelihood of fed-funds cut to 50 basis points (bp) this month is 85% and the likelihood of a cut to zero in the coming year is 60%. In late November, the futures markets indicated a 70% probability of a cut to 50 bp at the Fed’s December meeting. The futures were predicting a 32% chance of a cut to 25 basis points at that meeting.
Recent commentary has focused on the disparity between the fed-funds rate and the effective rate for fed-funds borrowing. The fed-funds rate is a target rate that the Fed normally seeks to match by its open market operations. The past two months the Fed has veered from its normal practice. For much of November the fed-funds were trading between in the 22bp to 40bp range – well below the target rate of 1%. In late November, it rose to about 50bp. Most Fed watchers believe this is a clear indication that the Fed will lower the rate to 50bp in December. An avalanche of bad economic data has made it increasingly likely that the Fed will take that step.
As Alan Greenspan made clear in his recent autobiography, the Fed attempts to control expectations and market sentiment. At the same time, the Fed is pressured by the expectations of the market to make changes. A recent CNN report stated, “Many economists say that fear and uncertainty in the market is so great right now that the Fed can’t risk leaving the rates unchanged.” If the Fed failed to cut rates in December, most likely, the market reaction would be highly negative. Fear and uncertainty have shifted power from the Fed to the market in this rate making context. Moreover, if the Fed intended to disappoint market expectations, they would have already begun laying the groundwork by public statements. They have not done so.
The likelihood of a cut all the way to zero has been steadily increasing. In the past month, former Fed governor Laurence Meyer stated, “The expected rise in the unemployment rate, paired with the rising threat of deflation, presents a risk that the FOMC [The Fed’s Board of Governors] will have to ease even further, perhaps all the way to a zero Federal Funds rate.” Current Fed governor Janet Yellen indicated that the funds rate may need to fall close to zero if the economy continues on its steep descent. Labor economists universally predict that the unemployment numbers will grow for many months. As the recession deepens and more bad economic data is reported, there will be market pressure to make further fed-funds rate cuts in 2009.
There are reasons the Fed may be unwilling to cut all the way to zero. The last time the fed-funds rate was at 50bp was in 1958. It has never been at zero. The Bank of Japan lowered its rate to zero in the 1990s. The Fed may fear being seen to emulate a bad example of monetary governance. The Governors may also be concerned about the psychological and market impact of reaching zero and appearing to run on empty. They may choose to expand the money supply through the alternative/aggressive steps that they have recently undertaken such as the purchase of mortgage backed securities.
Simply put, some Fed governors may be concerned about the public reaction to prospective newspaper headlines stating “Federal Reserve sets the borrowing rate at zero.”
There has been increasing conjecture among Fed watchers about what happens next if the fed-funds rate drops to zero. Several commentators have suggested that the Fed will then take the unprecedented, radical step of buying long term treasury bonds. Governors who are concerned about such a departure may vote to keep the fed-funds rates above zero to avoid opening that Pandora’s box.
There are a variety of additional policy reasons that argue against further cuts. For instance, lower rates punish banks (mainly community banks) that are net lenders of fed-funds while assisting money center banks that tend to be net borrowers. This shift of power potentially concentrates greater power in a small number of big players. It is likely that the Fed will ignore these downside risks in the rush to do whatever it takes, appease the markets and stimulate the economy onto an upward trajectory. During the current easing phase, the fed-funds rate has been lowered from 5.25% to 1.00%. Traditional concerns such as creating another inflationary bubble have been cast aside as if they were of no account.
Weighing and balancing the above considerations results in my projection that a zero fed-funds rate is 60% likely in the coming year.
The impact of reaching the bottom of this cycle is profound. As indicated in the prior note, the fed-funds rate was 20% in 1981. Over this 27 year period, there have been four cycles of increased rates, and five cycles of declining rates. Whether the bottom of this megacycle is at 50bp or zero, it will mark an important moment in our economic history. The fed-funds rate has been the principal tool of monetary policy for over 50 years. It has been the preeminent governmental tool to stimulate the economy for the past quarter century. When this megacycle is played out to the downside, the rules and operation of the game are certain to change.
In my next note, I will look at the likely course of the ten-year Treasury Note over the coming year. In late November, it fell below 3% for the first time since 1958 – a half century ago.
Addendum: After sending this article off for publication, on December 1 Fed Chairman Ben Bernanke in a speech in Austin indicated that there was limited advantage to further cuts in the fed-funds rate and stated that the Fed was considering the alternative of making "substantial purchases" of long-term Treasuries or agency bonds. As indicated above, direct purchase of such bonds would be a radical and unprecedented step. Based on Bernanke's statement, I remain convinced that the Fed will still lower the fed-funds rate to 50bp but believe the likelihood of a decrease all the way to zero is now 50/50.
I highly recommend David Rosenberg's (Chief Economist at Merrill Lynch) November 28, 2008 article on the Fed's interest rate policy. It is an exceptionally important piece, giving the implications of the Fed's actions for investors. It is available here (Adobe Reader required to view).
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