FOURTH-QUARTER BUY-IN TABOO IS A FUND FALL-ACY TO ONE ADVISER

Buying a mutual fund in October, November and December is about as fashionable as wearing white shoes in the fall.

While the dictates of style are difficult to alter, financial adviser Jay L. Shein is hoping to change the conventional wisdom about mutual fund investing.

Financial advisers typically tell clients not to purchase a mutual fund after Sept. 30 – or even a bit earlier – because they will face a tax hit after the funds distribute their gains and dividends. Rather than pay taxes for a period when they weren’t in the fund, better to sock money away in a relatively risk-free money market account and reinvest it at the beginning of the year.

Mr. Shein argues, however, that the opportunity cost of staying out of the market and missing out on potential gains can can be greater than any tax bill.

“You’re probably better off putting money in and paying taxes,” says Mr. Shein, whose firm is in Lighthouse Point, Fla. His argument will appear in an article titled “Is Opportunity Cost a Source of After-Tax Alpha?” in an upcoming issue of the Journal of Investment Consulting, he says.

a nagging question

The question of the hidden costs of staying away from mutual funds at the end of the year has nagged at Mr. Shein for a long time. He’d ask colleagues what this strategy was based on, only to hear, “That’s what they say.”

Mr. Shein wasn’t satisfied.

“I didn’t know who ‘they’ were,” he says.

Nine months ago he started to explore the validity of the conventional wisdom. He decided to look at three different beginning periods – Oct. 1, Nov. 1 and Dec. 1 – in each year from 1990 through 1998. In each scenario, the investor could invest in one of four instruments: a mutual fund, a money market fund, a Treasury bill and a large-capitalization U.S. stock index.

Investors who didn’t put their money in a mutual fund would sell their assets on Dec. 31 and invest the after-tax amount in a mutual fund on Jan. 1.

Mr. Shein looked at a total of 2,592 cases.

“I didn’t know how it would turn out, but it came out different from what everyone said,” says Mr. Shein.

Investing in mutual funds (the Beecher After-Tax Universe, encompassing 32 large funds, was the test group) generally won out. Investors who bought funds on the Oct. 1 and Nov. 1 beginning dates outperformed returns, on an after tax basis, of investors who bought a money market or T-bill in the same period. With the Dec. 1 beginning date, the investor was best off buying a mutual fund 58% of the time.

There was less difference between purchasing an actively managed fund and an index fund. An investor was further ahead buying a fund in October and November 50% of the time. However, the indexes won out 60% of the time with an initial investment in December.

There are some key assumptions made in the report. The investor’s tax bracket is figured to be 39.6% for ordinary income and short-term capital gains and 20% for long-term capital gains. Also, only federal taxes were considered, and cash flows in and out of funds were not. Also, the data covers a chunk of probably the best performing stock market in history.

Assess implications first

Even with those caveats, Mr. Shein believes the report demonstrates that advisers can’t be blithe about telling clients to hold off investing in a fund. Advisers should sit down and figure out the overall performance and return implications.

Robert Levitt, a planner in Florida, believes there is much food for thought in Mr. Shein’s work.

“It is something we will have to think about,” he says.

Advisers who do suggest that clients invest in a fund late in the year, however, must be ready to calm tax-sensitive clients.

“The final decision for the investor and consultant will never be easy,” Mr. Shein says in the article. “The logical choice may conflict with the emotional stress caused by having to possibly write a large check to the Internal Revenue Service.”