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You Can Do Better than Mutual Funds and ETFs with Your Cash

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You know how I feel about Fidelity and Vanguard. Great custodians, but there’s a better mousetrap than the mutual funds and ETFs they sell for stock investing. That’s why I favor individual dividend-paying stocks with a track record of consistent dividend increases. Do not take this as a call to immediately sell your mutual funds/ETFs, but it may be time for a revisit. How? Maybe look at your lazy money sitting on your couch, eating your ice cream, and doing nothing. Let’s go. Wake up. Get it out the door. Beat inertia.

Dividend investing isn’t a fad. It’s always in style if you care about investing based on metrics you can touch, like cash. In times like these when investors realize “price” is a qualitative event—the lump sum of opinions in a zero-sum game and hardly quantitative like cold hard cash—you need to protect what you make. Get off the sidelines. Let’s talk.

Akane Otani writes in The Wall Street Journal:

What’s unusual about this year’s rally in dividend-paying stocks is that it’s the opposite of what market convention says happens when interest rates rise. Usually, investors say, dividend-paying stocks do poorly in a rising-rate environment. That’s because rates typically go up when the economy is growing. In boom times, investors tend to forgo the steady cash payments of bondlike stocks in favor of companies that have the potential to deliver bigger profits down the line.

But this time around, a different dynamic is at play. Interest rates have risen swiftly, not because investors are betting on an economic surge, but because accelerating inflation is forcing the Federal Reserve to act quickly to try to rein in price pressures. Some investors worry the Fed’s interest-rate increases may even tip the economy into recession.

That has drawn investors into shares of big dividend payers, which promise to deliver a steady stream of cash in the near term. A bonus? Many dividend payers are in industries like utilities, telecommunications, and consumer staples, which consumers tend to rely on year-round, regardless of the economic environment. That has made them especially attractive to investors who are worried the Fed won’t be able to combat inflation without significantly raising unemployment.

Action Line: If you’re coming out of tax season wondering why your mutual fund had such high taxable gains, isn’t it time to think about a new place for your cash that’s doing nothing?

P.S. At Bloomberg, Annie Massa and Claire Ballentine report on Vanguard clients who feel betrayed, writing:

Mike Quinn does his own taxes.

He pores over IRS Publication 17, a guide for individual filers, with the zeal of a certified public accountant, and he meticulously calculates how much money to set aside each April.

But this year came with a stinging surprise — a tax bill roughly $30,000 more than he anticipated. That’s because Quinn, an independent contractor from New Jersey, owned two Vanguard Group retirement funds that racked up massive capital gains — an increase of more than 2,000% from the prior year — that fell almost entirely on the shoulders of unsuspecting individual investors.

Quinn, 56, is just one of potentially tens of thousands of Vanguard clients stuck with significantly higher tax bills this year because of a change the firm made to its target-date funds in late 2020, according to a class-action lawsuit filed March 14 in federal court in Philadelphia.

“I put faith in these guys for 20 years and lived through a couple of their foibles after Jack Bogle,” Quinn said, referring to Vanguard’s legendary founder, who died in 2019 and left a legacy built on lowering costs for retail investors. “This one was just too much.”

The Valley Forge, Pennsylvania-based company has a cult-like following among do-it-yourself savers, some of whom have voiced disappointment with customer service in recent years.

The tax debacle threatens to further erode that well of goodwill.

In December 2020, Vanguard made changes to its target-date funds, which allow investors to choose a year when they plan to retire and then let the firm handle the rest — changing a fund’s asset mix to gradually become more conservative as the target date approaches. Indeed, Bogle embraced an investing philosophy of “set it and forget it” — tailored to investors with neither the time nor inclination to actively manage their own portfolios.

Vanguard had two classes of funds — lower-fee institutional funds and more costly retail funds. Seeking to stay competitive against other large asset managers, the firm lowered the institutional funds’ minimum investment for retirement plans to $5 million from $100 million.

That triggered an “elephant stampede” — as Wall Street Journal columnist Jason Zweig described it — with money pouring out of the retail funds and into the lower-fee institutional funds, forcing Vanguard to sell assets from the retail funds. Assets at Vanguard’s 2035 target fund dropped $8 billion to $38 billion, and they fell by $7 billion to $29 billion in the 2040 fund.

While institutions and other investors with tax-advantaged accounts such as 401(k)s and IRAs weren’t adversely affected, the resulting capital gains fell on the pool of retail investors with taxable accounts who remained in the higher-fee funds.

This, according to the plaintiffs, was reckless and unnecessary. Vanguard, they claim, could have simply merged the retail and institutional funds from the beginning because they had the same strategy, asset mix and management. In fact, the firm decided to do just that in September, but after the damage had already been done, attorneys for the plaintiffs said in the complaint.

“Vanguard had other, readily-available ways to lower costs for retirement plans without hurting its taxable investors,” they wrote. “But it either did not even consider these options, or did not care about hurting its smaller, taxable investors. This was a gross violation of Vanguard’s fiduciary duties.”

The company and Chief Executive Officer Tim Buckley are named as a defendants, along with more than a dozen other executives and trustees.

“Vanguard has a long-standing history of reducing costs across all products, strategies, and asset classes to directly benefit investors,” spokeswoman Emily Farrell said in a statement. “By dropping investment minimums for our target-date funds, we broadened access to lower-cost options for employees in small employer 401(k) plans. And by lowering costs for these funds, we helped millions of investors in individual accounts and retirement plans retain more of their returns.”

Lisa Greene-Lewis, a CPA with Intuit Inc.’s TurboTax, said that a surprise tax situation like the one outlined in the lawsuit could force unprepared investors to sell assets to come up with enough cash.

“They have to figure out quickly how to pay that tax bill,” she said. “They could use savings, or if they have some other assets, they might sell those to pay what they owe, but that’s like a snowball.”

Other plaintiffs include Valerie Verduce of Georgia, who held Vanguard’s 2020, 2030, and 2040 retail funds in taxable accounts. Those products distributed more than $60,000 in capital gains last year, leaving her with an estimated $9,000 tax liability. Another, Anthony Pollock of California, invested in Vanguard’s 2025 and 2035 retail funds and saw the holdings distribute more than $105,000 in capital gains, leaving an estimated $36,000 in tax liabilities. Catherine Day of Massachusetts invested in the 2025 and 2030 retail funds, which distributed more than $80,000 of capital gains, resulting in a estimated $12,000 tax liability, according to the lawsuit.

Quinn, who held Target Retirement 2030 and 2035, said he was outraged by the capital gains on the two funds. The year-over-year gains on the two funds far exceeded the average gains of just 1.9% on all other Vanguard funds he held.

“Vanguard has been great with fees — they’ve always been low,” Quinn said. “But this tax hit, and the reason for it, was infuriating.”

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E.J. Smith - Your Survival Guy

E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. His focus at all times is on preparing clients and readers for “Times Like These.” E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zildjians. He grew-up worshiping Neil Peart (RIP) of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@yoursurvivalguy.com To sign up for my free monthly Survive & Thrive letter, click here.