Mutual Funds Are Good, But IMAs Are Better.

• Author: FRAMSON, JOEL H.
• Position: Individually managed accounts - Statistical Data Included

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...