Mutual Funds Are Good, But IMAs Are Better.

Individually managed accounts (IMAs) have generated a lot of press recently within the investment management community. The tax efficiency of IMAs over mutual funds is one reason for the heightened interest. For your high-net-worth clients, IMAs are often a better method of investment than mutual funds, for a variety of reasons.

There are a number of terms used for IMAs. In some circles, they are referred to as "separately managed accounts." The terms are synonymous. The common denominator is that they both hire professional investment managers to pick individual securities for the portfolio.

HOW ARE IMAs DIFFERENT?

Unlike a mutual fund, IMAs are purchased separately for each client. Consequently, a new cost basis is generated when an IMA is created. And, unlike a mutual fund, each security is listed on the client's monthly account statement. Looked at another way, with a mutual fund, you own a piece of the basket of stocks--with an IMA, you own the whole basket.

Mutual funds have proliferated over the past 20 years to the point where now, Morningstar tracks more than 11,000. Mutual funds are so popular due partly to their easy accessibility and partly to the immediate diversification they offer. Where else can an investor own a piece of Microsoft, Cisco and Intel with as little as $100? For the stock investor, mutual funds offer a plethora of choices, including alternate styles from large-value stocks to small-growth stocks, passive or active, domestic or international, as well as a variety of market segments, from biotechnology to utilities.

In short, a mutual fund offers virtually every asset class, whether you are looking for fixed income, gold, real estate or commodities. And each mutual fund offers full-time professional management.

TAX DANGER

However, the seed of discontent grows within this same pool of investment choices. To offer the small investor instant diversification among hundreds or thousands of securities, mutual funds must pool investor dollars. Since the pool of investments already exists, the new investor purchases securities with an original cost that might extend back many years. The potential danger is that the unrealized appreciation from years prior to purchase of the mutual fund could become your client's income tax burden.

For example, a low-turnover fund such as Vanguard S&P 500 Index began in 1976. Morningstar reports that the potential income tax exposure is 47 percent. Let's look at the following example of the worst-case consequence:

New Investment in Vanguard S&P 500: $10,000

Original cost of securities: $5,400

Appreciation--Potential Form 1099 Income: $4,600

In this example if there were massive redemptions of the fund, or if the fund decided to close, the unrealized appreciation would be taxed to the new investor. The federal tax cost would range from a low of 20 percent ($940) if treated as long-term capital gain, to as high as 39.6 percent ($1,861) if the appreciation was short-term gain. While this is the extreme case, the potential for getting hit with part of this gain as well as experiencing an economic loss at the same time is not uncommon (see box).

This problem of built-in gains is related to another phenomenon: phantom year-end income. When a mutual fund trades its securities during the year, it often generates short-term capital gains. When the time for tax reporting comes around, the fund lumps these gains with ordinary dividends and reports the total on Form 1099, to be picked up as ordinary income.

Although the investor does not see this phantom income (and certainly will not get close enough to it to spend it), there will be a very real tax bite come April 15. Now let's consider the dreaded double whammy, described below:

Cost of mutual fund $10,000

Year-end value of mutual fund 7,500

Loss ($2,500)

Phantom income $2,000

Assumed federal tax rate 39.6%

Federal income tax $792

In this example, the mutual fund generated an economic loss of $2,500 for the year. To make matters worse, due to its securities trading during the year, it generated ordinary income in the amount of $2,000. Thus, not only did the investor lose money, but adding insult to injury, their tax bill increased by almost $800. This is a very real possibility, especially given the sell-off in the technology markets experienced earlier this year.

In a somewhat related issue, consider what would happen if the mutual fund generated a net short-term capital loss instead of a short-term gain of $2,000 in the above example. Unfortunately for the investor, the short-term loss would not pass through to the investor to reduce other income. A mutual fund must defer this loss and carry it forward until it can be used against net income.

STYLE DRIFT 

Style drift is another disadvantage associated with mutual fund investing. Fidelity Magellan, practically a household name in mutual funds, gives us a good example of this. Assume that you purchased this fund several years ago to provide exposure to smallcap growth-oriented stocks. When the fund grew too large, it was forced to start buying bigger and bigger companies until it ended up being a large-cap mutual fund. Then, without warning, the fund manager used his discretion to sell all the stocks and turn the fund into a bond fund. No sooner did this manager leave than the fund became an S&P 500 twin. So much for trying to take control over your own portfolio and maintaining the asset allocation strategy.

BETTER TAX EFFICIENCY

In an IMA, all securities are purchased specifically for the client portfolio. This creates a number of tax efficiencies.

* Cost-basis control

* No built-in gain

* Loss harvesting

* Doubling-up technique

* Use of low basis stock to fund account

* Charitable and gifting strategies

Since the cost basis of each security is established for each client portfolio when purchased, the IMA starts off with no built-in gain. The only gains that an investor will be taxed upon will be the recognized gains for this specific portfolio--there will be no phantom income due to the actions of other investors.

Because the cost basis can be controlled, the separate account manager can employ loss-harvesting techniques. Using this technique permits the manager to better control the portfolio's tax consequences, and therefore its after-tax returns. For example, assume that the portfolio acquired 25 shares of Microsoft each year for the past four years and now owns 100 shares. The following table might depict the purchases of this stock:

1. 25 shares bought 12/15/97 @ $35 $875.00

2. 25 shares bought 12/15/98 @ $65 $1,625.00

3. 25 shares bought 12/15/99 @ $120 $3,000.00

4. 25 shares bought 09/15100 @ $50 $1,250.00

Total Cost of 100 shares $6,750.00

Average Cost per Share $67.50

Now, at the end of the year 2000, the manager decides to sell 25 shares of Microsoft. What will be the cost basis of the shares sold? If this were a mutual fund, chances are the average cost of $67.50 per share would be used, producing a cost for the 25 shares of $1,687.50. In the IMA, we have the opportunity to sell the third lot purchased at $120 per share. This tax-efficient tool allows us to do better tax planning for our clients with respect to their portfolios.

DOUBLING-UP

Doubling-up is another portfolio management technique that is available in an IMA. Doubling-up enables the manager to recognize a loss for tax purposes while maintaining a position in a specific stock. To avoid wash sale rules, the manager purchases an equal number of shares in the current stock, thereby doubling the portfolio position. After 30 days, the original shares are sold with the intent of recognizing the loss. The higher-basis shares continue to be held in the portfolio.

IMAs also facilitate gifting and charitable stock donations. If the portfolio includes low-basis shares, whether acquired through stock options, inheritance, or simply purchased many years ago, the separate account manager can be directed to remit those shares in satisfaction of a bequest. With highly appreciated securities in the portfolio, this method will often produce a better result than could be obtained by gifting a mutual fund, since it allows for culling through the portfolio to find the optimal securities from a tax standpoint.

Due to the recent surge of stock options, more investors today than ever before seem to have problems with overly concentrated portfolios. How do we as advisers accomplish two tasks at the same time--diversification and tax-cost management? If we use a mutual-fund strategy, all of the company stock would need to be sold immediately. In an IMA, however, we can work with the portfolio manager on a completion strategy to effect the desired asset allocation over a targeted time period. First, many IMAs will accept existing stock positions as part of the initial funding of the account. While this does not give us diversification right away, it does give us the flexibility to decide whether to margin the position to gain liquidity or embark on a systematic selling schedule.

Further, if the position is in one market sector, we can work with the manager to limit further purchases of securities in that sector and avoid over-weighting the portfolio.

IMA COSTS

Cost is one often-cited IMA disadvantage. While it is true that using an IMA will be more expensive than a passively managed mutual fund, the cost is generally no more than when using an active mutual fund manager, possibly less. In fact, as the portfolio size increases, the relative cost of an IMA decreases due to break points. Consider that a mutual fund expense ratio of 1.4 percent will remain at that level whether the investment is $1 or $1 million. However, in an IMA, the fee would typically drop from an initial 1.1 percent down to perhaps .7 percent, as the dollar amount gets larger.

Consider too the emotional side of investing, the cachet, the bragging rights, the identification of exciting companies in the portfolio. Too many clients are prone to setting up outside "play money" accounts in order to own hot stocks like Cisco, JDS Uniphase or Nokia. Many of them do not understand that they already own these great companies and more if they would just take the wrapper off the mutual fund and look inside. In fact, too many clients own these same securities in a number of overlapping mutual funds, thus taking away some of the benefits of diversification.

When your client receives the separately managed account statement at the end of the month, they see each stock or security as a line item. They see each buy and each sell in the portfolio. This often transforms client perception; with an IMA, they can relate to the securities rather than to merely the name of a mutual fund whose star ratings seem to change as frequently as the night sky.

IMA DISADVANTAGES

There are disadvantages to using separate accounts, of course. They still are not available to your non-wealthy clients, because the minimum per manager is about $100,000 for equities and $300,000 for bond managers. This means that to use several managers to obtain proper diversification, this strategy will still require a minimum portfolio of about $800,000. Even on a portfolio of that size, a 10 percent allocation would still require the use of a mutual fund due to the restriction of the separate account minimum.

Other aspects to note include the portfolio rebalancing decisions and the deduction of the fees relating to the investment. In the IMA, the periodic portfolio rebalancing will be a bit more cumbersome and time consuming. With a mutual fund, buying or selling the fund easily accomplishes the rebalancing. When rebalancing the IMA, the selling process requires looking at the individual holdings and making decisions on each security. And while the annual expense charged by a mutual fund is netted against the returns, the fee charged by the IMA must be deducted as a miscellaneous itemized deduction. If the client is affected by the alternative minimum tax, the deduction is effectively lost.

Nonetheless, the case for using separate account managers as an investment strategy is strong. Some of the strongest arguments for CPAs should come in the form of potential tax efficiency. And although it may be more credible with high-net-worth clients, the strategy allows the investment adviser to build a portfolio like you would build a custom home--adding more value through the tools available than might be obtained by going the route of a tract home.

Joel Framson is partner in Glowacki Framson Financial Advisors in West Los Angeles, which specializes in wealth management services for the high-net-worth client. He teaches portfolio theory for the Education Foundation, and is a former state PFP Committee chair and a member of the AICPA's Executive Committee's PFP Division.