A down year for mutual funds, especially at tax time

You will never go broke paying taxes. A good friend and fellow adviser likes to remind clients of that at this time of year. The idea, of course, is if you owe taxes on your investments, it's because they are making money.

What is harder to explain is why some investors end up with a hefty tax bill in a year their investment portfolio has lost money.

After a sharp sell-off this month, the major U.S. equity benchmarks are down 7-to-10 percent year-to-date. Even if Santa brings a late December stock rally, any investment gains are likely to be minimal.

What may not be minimal is your 2018 tax bill, especially if you own mutual funds.

Here's how mutual funds are structured: Each fund is a collection of individual stocks bound together into a single product.

As fund managers make changes and sell some of those stocks throughout the year, it creates a realized gain for the fund's shareholders. Most mutual funds distribute those realized gains, plus the stock dividends, at the end of the year.

It's not unusual for a fund to distribute 10 percent of its assets as capital gains in a single year, meaning a $75,000 investment would result in a $7,500 taxable gain.

The tax inefficiency of mutual funds is nothing new, but it's a problem that's getting bigger. According to the Investment Company Institute, stock and bond funds paid out a total of $641 billion in distributions in 2017.

That was the largest amount in history and indications are the 2018 totals could be even higher. With equities trading near all-time highs, fewer losses are available to offset gains.

Passively managed index funds are not immune from these inefficiencies either. It's true index funds have lower annual turnover (less buying and selling) than actively managed funds, but if there are more redemptions than new contributions in a given year index funds will be forced to sell assets in order to create the cash needed to fund those withdrawals. In that scenario, you can end up with a sizable distribution and tax bill even if you personally withdrew no money from the fund at all.

To be clear, funds can still be a good fit for the right investor. They provide built-in diversification, which is especially attractive if you are starting with smaller dollar amounts. Index funds typically have no upfront sale charges and offer low internal expenses. It's also important to point out that funds owned inside qualified accounts (IRA's, 401(k)s, etc.) are sheltered from current taxation.

That said, individual stocks and individual bonds often provide greater benefits and more flexibility. With stocks, tax planning can be customized to each individual investor. For those who reside in higher tax brackets, harvesting losses can save thousands of dollars each year.

A good adviser will consider both a company's growth outlook and current valuation, among other things, when selecting the most attractive stocks. The most popular index funds, on the other hand, are weighted by market-cap and give zero consideration to valuation when determining their holdings.

Usually, the debate about investing in funds vs individual companies pertains to equities, but it's just as vital to the conservative part of your portfolio.

Bond funds have grown immensely in their popularity, partly because of their convenience and partly because declining interest rates for the last 30 years have effectively boosted total returns.

Now that rates have begun to increase, however, many bond funds are vulnerable to losses. The Bloomberg Barclays Aggregate Bond Index owns a higher average duration and a lower credit quality than it has for most of its existence. That equates to more risk, which is rarely the goal when it comes to bonds.

Mutual funds and index funds have their benefits, but also come with limitations. It's important that investors consider all their options. The most convenient or least expensive choices are not necessarily the best solutions.