Funds vs. Individual Securities: Part One - Tax Efficiency

Intro

Narwhal was founded on a strong conviction in the benefits of selecting individual stocks and bonds for its clients and not relying on the use of funds to fill portfolios. This adherence to individual security selection is at the core of who we are as investment advisors and is an ideal that we do not intend on abandoning. Why is our belief in this way of operating so strong? What follows is part one in a three-part series on the factors that lead us to believe in the advantages of the old school method of selecting individual securities over ETFs and mutual funds.

What is a fund and why do people invest in them?

Before we get too far into our discussion, it might be helpful to review what funds are and why people choose to invest in them. At a very high level, a fund is a collection of assets that are pooled together and then distributed across different investments. There are many different types of funds, but two that are often talked about when it comes to investing are “exchange traded funds” (ETFs) and “mutual funds.” These two types of funds are structurally similar in that they are both comprised of pooled assets that are invested over a wide range of securities (stocks, bonds, commodities, etc). As an investor, you can purchase shares of these pooled investments that allow you to own a small piece of the overall investment portfolio, a portfolio that owns numerous securities, meaning that your small investment is spread out over all the investments owned within the fund. This is one of the biggest reasons why individual investors are attracted to funds. With a small amount of money, you can diversify across a large number of investments, theoretically reducing the risk you take on as an investor. Another advantage of funds that attracts so many investors is the ease of which you can achieve this diversification. Instead of going out and buying shares of all 500 companies that make up the S&P 500, you could buy one share of an ETF that has a portfolio comprised of all the companies in the S&P 500. Another benefit realized by those investing in funds is that, generally, they are a cost-effective investing option. I say generally because this isn’t always the case, but there are plenty of funds that an individual investor could choose to invest in that are fairly low-cost. These factors certainly make a compelling argument for investing in funds, so why would we avoid these types of investments?

Why does Narwhal select individual securities?

Narwhal’s conviction in owning individual securities rather than funds is driven by three factors: tax efficiency, cost reduction, and investment performance. We believe these factors provide real value to our clients and make the more time-consuming task of selecting individual securities worth the effort. All three will be discussed in detail going forward, but this post will focus on the tax benefits that can be achieved through individual security selection and why this flexibility is so valuable. It is wise, however, to point out that there are circumstances in which Narwhal would buy a fund (almost always an ETF) for a client. The most common circumstance would be to gain exposure to commodities, specifically gold, as funds are the only feasible way for us to own gold for a client. Outside of commodities, we will, from time to time, purchase a fund in an area that we are convicted about but that lies outside of our expertise. This is exceedingly rare for us, but again, it is important to point out that there are instances in which we may hold a fund for a client. Outside of those few circumstances, we focus solely on individual securities because of the reasons listed above. Not only do we believe in the value that this process provides, we feel strongly that, because our clients pay us to invest for them, we should be the ones deciding on the investments they hold, rather than leaving it up to a fund manager.

How are taxes tracked within a portfolio?

To understand how taxes work inside an investment portfolio, it is important to be familiar with the concept of a realized loss and a realized gain. The value of a security is constantly fluctuating. Whether that fluctuation leads to an increase or a decrease in value, the change in value isn’t solidified until the position being held is sold. The act of selling out of the position and collecting the difference between the original price you paid and the current price of the security is called realizing the value of the position. When selling out of a position that has increased in value you are realizing a gain, and when selling out of a position that has decreased in value, you are realizing a loss. These concepts are important to understand because of the implications they have on taxes within a portfolio. Each time you realize a gain on a position, you create a tax burden on the value that you gained through that sale. If you bought a share of Apple at $100 and sold it at $120, you are expected to pay taxes on the $20 that you gained. On the flipside, each time you realize a loss on a position (sell a share that has decreased in value) you create a tax deduction on the value lost on the sale. If you bought that same share of Apple at $100 and the value dropped to $80, you would have a tax deduction within your portfolio on that $20. This tax deduction can be used to cancel out the tax burden created by a realized gain.

Tax efficiency of individual stocks vs funds

To illustrate the tax efficiency gained by owning individual securities, say you buy $100,000 worth of shares of an ETF. You let the money sit in the ETF for one year, and during that time your investments grows 20%, increasing to $120,000 in value. After the year is over you decide you want to use that money to put a $60,000 down payment on a new house. You sell half your shares of the ETF to do so (half of your investment is now worth $60,000). The act of selling shares that have increased in value is considered a realized gain, and (as we discussed in the previous section) that realized gain triggers a tax obligation. So, originally, half your investment was worth $50,000, but it increased in value to $60,000, which is the point at which you sold it, meaning that you realized a gain of $10,000 on the transaction. You are now obligated to pay capital gains tax on that $10,000 increase, at a rate of (more than likely) 15%, creating a tax burden of $1,500 for the year. While this isn’t the end of the world, any one of us would rather not pay that $1,500 if we could avoid it.

Now consider a second scenario. Instead of buying shares of an ETF, you decide to invest in ten different individual stocks that you like, in round investments of $10,000 each. Over the course of a year, four of the ten stocks have outstanding performance, returning 50% ($40,000 growing to $60,000), two of the ten perform well, returning 20% ($20,000 growing to $24,000), one of the ten remains flat over the year, returning 0% ($10,000 staying at $10,000), two perform very poorly, returning -10% over the year ($20,000 shrinking to $18,000), and the final investment fails miserably, returning -20% on the investment ($10,000 shrinking to $8,000). All said, your original investment of $100,000 has still grown by 20% to $120,000, just like in the original scenario. To make this information a little easier to follow, I laid out the investments in a table inside the link below.

Investment Table

Again, just like in the original scenario, you decide that you would like to place a $60,000 down payment on a house and want to sell half your investment to do so. But unlike the original scenario, you now have some flexibility on what you would like to sell because you own ten different investments instead of one. You decide you want to start with the worst performing stocks and work up, so your first sale is the investment in stock K, which was originally worth $10,000, but at the time of the sale is now worth only $8,000. By selling a stock that has decreased in value, you are realizing a loss on the transaction ($2,000), which acts as a tax deduction within your account. After that investment is sold, you have $8,000 in cash toward the $60,000 total that you need for the down payment, and you also have a $2,000 tax deduction. Next you move on to investments I and J, which were originally worth a total of $20,000 but at the time of the sale are worth $18,000. You complete the transaction, convert the investment into $18,000 in cash, and in doing so, collect another tax deduction of $2,000. You now have $26,000 in cash and $4,000 in realized losses. You move on to sell out of investment H, which ended the year at the same value it started, returning 0%. Because there was no gain or loss on that position, you don’t receive a tax deduction, but you also don’t generate a tax burden, so you are able to turn that investment into cash without any issue. That is another $10,000 in cash bringing your total to $36,000, while still having a realized loss of $4,000. In order to raise the final $24,000 that you need, you have to sell out of investments that increased in value over the year. Investments G and E both returned 20%, bringing the total value of the two investments from $20,000 to $24,000 at the time of the sale. As you complete the sale of those investments, you realize a gain on the positions of $4,000 ($2,000 increase on both investments). A realized gain triggers a tax burden inside of an account, so normally you would be obligated to pay taxes on the $4,000 increase on those positions, but luckily, you have $4,000 in tax deductions from the losses you realized through the sale of the first three investments (stocks K, J, and I). That $4,000 tax burden brought on by the realized gain of selling stocks G and E is nullified by the tax deduction brought on by the realized losses of stocks K, J, and I, leaving you without a tax obligation on the $60,000 worth of investments you sold.

Compare the result of the second scenario to the original. Both raised equal amounts of cash from portfolios that had the same performance over the year, but one situation led the investor to pay $1,500 in taxes while the other scenario didn’t create a tax burden at all. While this tax burden may not sound overwhelming, this example only considered these investments over a one-year timeline. Imagine if this example had been stretched out over twenty years, the tax burden would have grown as the portfolio increased in value, making it more difficult to make adjustments within the portfolio when cash needs arise or when convictions change.

Are there any consequences to using this method?

Some may argue that utilizing your losses in this manner is only delaying the inevitable, and that you will be faced with even larger capital gains in those remaining positions down the road. While that is true in part, it is impossible to say when or if you will ever need to satisfy another large cash need by selling out of the remaining positions. It is also very likely that, if you choose to continue putting money aside for investments, you will choose some investments that work well and some that don’t work so well, creating more opportunity to realize losses and negate some of the realized gains on these established positions. There is also another option that we encourage our clients with large gains in positions to take advantage of. If you are considering doing any sort of charitable giving, you can do so by donating shares of stock to your desired organization rather than giving cash. Those receiving the donation do not have to pay any taxes upon selling the shares, so to them it is as good as receiving cash, and for the individual donating, it allows them to work out of those tax burdened positions while utilizing the cash they would have donated to buy into new investment opportunities. This is an excellent strategy that is hugely beneficial for both parties and is always something we would be happy to help discuss with you.

Conclusion

Taxes within a portfolio aren’t inherently a bad thing, they are a byproduct of portfolio growth, and after all, portfolio growth is the goal of this whole endeavor. However, if you have the chance to reduce the amount of taxes that you are obligated to pay, you would be silly not to. The above example shows the agility that is available to investors that select individual securities rather than piling money into funds and letting it grow without any consideration for the constrains they are putting on their assets. These constrains are magnified over time, leaving many unable to make adjustments inside their portfolios. The flexibility to reduce your tax burden is something that can be achieved when you hold a portfolio of individual securities rather than funds and is one of the biggest reasons why Narwhal implements an individual security selection strategy for its clients. Part 2 of our series on funds vs individual securities will focus on the real cost of holding funds through the examination of hidden fees.