No-load mutual funds are just about the most ideal building blocks for a globally diversified asset allocation plan you’ll ever find. The combination of instant broad diversification, liquidity, and low cost makes them the thinking investor’s medium of choice. However, no-load funds are not the only possible way to achieve these goals, so let’s look at a few alternatives.

Closed-End Funds

Closed-end funds are closely related to the more common open-end fund. Open-end funds continuously offer new shares to the public, and provide liquidity via redemption of shares at net asset value. Closed-end mutual funds do not redeem shares directly from the public the way open-end funds do. Rather, liquidity to the investor comes through sale of shares to another investor on an exchange or over the counter.

New closed-end funds are almost always sold at a Public Offering Price, which includes a generous sales allowance or commission. As you recall, often these products are touted as being sold without commission. Technically correct, perhaps, but morally questionable. In fact, the initial investor is usually really only buying 96 cents or less of stock for each dollar. So nobody should be surprised that after the initial offering is sold out, and the fund begins to trade on a market, the price falls to the real net asset value. Why anyone would buy an initial offering is beyond me. However, the brokers receive several times as much commission — whoops, I mean offering allowance! — for initial offerings as they would for an after-market trade. So, they generally sell out.

But more often than not, the price continues to fall. It’s not unusual to see the price stabilize at about 80 to 85 percent of the net asset value. If you would like to cruelly torture economists, just ask them why this happens. This effect is so persistent and widespread, that it is often cited by opponents of the efficient market theory. One likely cause is the effect of hidden tax liabilities within the portfolio. But this can only explain a small part of the difference. The problem has resisted rational solution, and tends to make economists a little nuts.

Occasionally, optimism for a particular fund will drive the market price far above net asset value. Only the “greater fool” theory can explain this apparently irrational pricing.

Some investors track trading patterns and attempt to buy at historical low points and sell when the spread narrows. Of course, the spread may never narrow, or it may even get worse. The stock market has no memory, doesn’t think it owes you anything, and will make no attempt to recoup your price.

Closed-end bond funds often trade at steep discounts. It’s hard to resist the temptation to buy a dollar’s worth of bonds for 80 or 85 cents. Investors looking for income can receive a handsome increase in yield by taking advantage of the discounts when they occur. This strategy is certainly worth looking into. While it may not eliminate all the problems with long-term bonds, it certainly can pad the income stream.

Closed-end funds are often proposed as a good solution to the problem of highly illiquid markets. In India, for instance, settlement of stock transactions can take weeks or months. Other nations may have restrictions on the flow of capital out of the country. An open-end fund might have trouble liquidating shares in a small market to meet redemptions. But a closed-end fund doesn’t have that problem. So the closed-end fund offers us access to a market that we might not otherwise be able to enter; it solves the liquidity problem through another mechanism.

What we often observe is that a closed-end fund begins to trade on the domestic market more like a domestic stock than the foreign market it is supposed to represent. So, for instance, if U.S. investors turn negative, they may first decide to dump their foreign holdings. The price of an India fund may suffer without regard to what is happening in India. The difference between net asset value in India and market price in New York may diverge sharply. Normal arbitrage cannot straighten out this strange result. So you may not get all the diversification effect you expect from the market.

A partial cure for this price disparity is to have a limited life for the closed-end fund. At the end of the limited life, either the stocks are all sold or the shares transferred in kind to the holders. Neither is a perfect solution. One comes at the price of some pretty dramatic tax events, and the other unloads the problem of selling the shares on the investor, who presumably bought the fund to avoid those costs and aggravations. Many investors will buy limited life shares at a discount and wait for fund termination. However, they still run the risk that, at termination date, net asset value will have fallen below what they paid.

I would never buy a new offering. Chances are high that I can buy it at a steep discount somewhere down the road. I would never pay a premium in the after market. And, if I woke up one day to find that a fund I owned was trading at a good premium, I might be severely tempted to sell it to that greater fool, and buy another one someplace else at a discount.

Unit Investment Trusts

Unit Investment Trusts (UITs) are very much like closed-end funds, except that rather than try to manage a portfolio of stocks or bonds, they just buy a pool of assets, and hold them. This approach reduces management costs to close to zero, but some very minor custodian and administrative costs remain. UITs are most often seen with bonds or muni bonds. Investors receive interest and their pro-rata share of proceeds as bonds either mature or are called. Investors must not fool themselves into believing that a UIT can magically “lock in” a dividend. Our experience over the last 20 years of falling rates has been that calls quickly eroded the portfolios. Like their cousins the closed-end funds, prices can diverge rather far from net asset value, and some investors enjoy trading as prices fluctuate.

In summary, both closed-end funds and UITs can be a useful tool as part of a properly designed investment plan. But, like everything else, they have their own risks and rewards.


Real Estate Investment Trusts (REITs) are corporations that have elected special tax treatment. As long as their business is real estate, and they distribute almost all of their income each year, they are not taxed at the corporate level. Once formed, REITs stock can be sold as any other stock either over the counter or on an exchange. Many REITs own diversified properties all over the country. Investors who wish to hold real estate may find this a handy way to own a quality portfolio, have instant liquidity, and avoid the sometimes almost unlimited aggravation of being a landlord.

The trend of converting real estate to securities via the REIT structure is accelerating. As the real estate partnership/insurance/banking/savings-and-loan debacle left over from the excesses of the 80s winds down, major institutions view REITs as a likely way to unload distressed properties and convert their headaches into liquid assets.

How well REITs track the performance of real estate triggers a lively debate. In other words, do REITs perform along with the real estate fundamentals or act more like a stock. One opinion holds that Wall Street has never appreciated real estate, and hasn’t the foggiest notion of how to properly price REITs.

The opposition holds that individual parcels of real estate are often irrationally priced, and that the local individual real estate market is hopelessly inefficient. This inefficiency occurs due to the scarcity of transactions, and the inability to properly compare unique parcels of land and buildings. This school holds that when real estate is converted to actively traded securities, the market can do a far better job of sorting out real value than can the localized individual transactions.

If you like REITs, you should love real estate mutual funds that hold only REITs and other real estate related stocks.

Real estate often holds an almost mystical attraction to many investors. They see it as a unique asset, a great store of value, a refuge from the vagaries of the stock market and an infallible inflation hedge. Many real estate funds are attractive because of their high yield, and so they may become a bond substitute to some investors. In practice, REITs seem to have a high correlation to small company stocks and high sensitivity to interest rates. If so, real estate funds don’t offer much in the way of a diversification benefit, and we wouldn’t expect them to be a great refuge in a market downturn. Recent experience tends to bear that out. They did well in a good market during 1993, but tanked along with other interest-sensitive offerings in 1994.

That year’s dismal performance came in the face of rising expectations for real estate. The industry was just beginning to dig out from the excesses of the 1980s. Occupancy and rental rates were up, and construction was beginning to make a comeback. A fly in the ointment was the threat of further interest-rate hikes, which would cut the availability of financing for both new and existing buildings. This would have a negative impact on the number and price of buildings that trade. Real estate funds were hard hit by the rise in interest rates that year. If it looked like a bond or smelled like a bond, it was properly punished.

So real estate funds act a lot like bonds, a lot like small company stocks, and perhaps not enough like buildings. In a down market, I wouldn’t expect them to be the very best-performing asset class. Whether they add enough in the way of diversification to justify adding them to a properly balanced portfolio is an ongoing question. If you like the idea of REITs, perhaps you should carve out a portion of your small or medium cap domestic growth allocation to make room for them.

Wrap Fee Accounts

As investors began to resist the traditional “churn and burn” brokerage tactics, Main Street began to turn to mutual funds in a serious way. Independent mutual funds addressed many of the investor’s concerns on cost, conflict of interest, and management. Worse yet, no-load funds were grabbing an increasing market share. The handwriting was on the wall. Traditional brokerage of individual shares was in danger of extinction along with other dinosaurs. In an effort to protect some of their high margin prestige business, Wall Street responded with The Wrap Fee Account. Voila! A public relations miracle. The commission-crazed broker has magically turned into the impartial professional. A new title of “Financial Consultant” completes the mystical transformation!

At first glance, Wrap Fees appear to correct many of the most glaring abuses. But a closer look exposes just another PR Band-Aid, a new set of proprietary products with even higher fees, poorer performance, and higher profit margins than proprietary mutual funds. The conflicts of interest aren’t gone, just better hidden.

Like vanity license plates, wrap fees are often marketed to affluent investors who want “more” than a mere mutual fund can deliver. Wrap fees continue the mystique of “individual” investment management, “private” deals, and individual issues. In fact, wrap fee accounts may be great for the ego, but bad economics. Due to the substantially higher costs associated with the programs, they can be expected to deliver less than other alternatives.

The wrap fee supposedly covers the entire spectrum of services including the broker’s compensation, thus eliminating any temptation to churn the account, and provides for a higher level of management expertise.

Clients are allowed a limited choice among in-house or house-approved managers. While clients own individual issues in their accounts, investment decisions are rarely personalized. Rather, the manager makes block trades, and a computer distributes shares between client accounts.

Each manager is expected to trade through only the introducing brokerage house. Hidden profits on trades in bonds or stocks where the house makes a market remain with the brokerage house. Many observers have opined that these undisclosed gains from trading are high enough that the brokerage houses could very profitably offer the Wrap Fee accounts for no charge.

For the sake of discussion, let’s discount all these problems to zero. A fatal flaw still remains for an investor who wishes to have an appropriate asset allocation plan. Unless you have true mega-bucks, you are just not going to be able to participate in many desirable markets and segments of markets by using wrap fee managers. Suppose you had a $1 million account, and wished to place 10 percent of it in the “Tiger” Economies of South East Asia. Where are you going to find a competent manager with expertise in the region willing to take an account for $100,000? It’s not going to happen. And even if it did, how is that manager going to properly diversify your $100,000 over 10 to 15 economies using individual issues? At the end of the year, how are you going to re-balance the account, or liquidate a few percent to provide income for yourself? The practical reality is that it cannot be done efficiently. Cost is prohibitive, competent management highly unlikely, diversification impossible.

Variable Annuities

As we observed in Chapter 10, taxes are a problem for many investors, but mutual funds present a couple of interesting wrinkles. One partial solution is the use of index funds to reduce the tax burden, however, there is another alternative: variable annuities.

Deciding whether a variable annuity is a good choice is a very complex task – even with a very powerful computer program. The issues are reasonably tricky, and there are a few wild cards.

Variable annuities pay about the highest level of commissions available in the securities industry. So, you might expect they are rather aggressively marketed. The hype can get pretty deep. Still, used in the right situation, they can be a very valuable financial tool. So here’s a rundown.

Insurance companies sell variable annuities, but they don’t usually actually invest the money. Instead, your cash goes straight into a group of funds (separate accounts). If you are a tax lawyer you might get pretty excited about the difference between a separate account and a mutual fund. The rest of us will find the distinction incredibly boring. I will spare you the details.

Tax advantage

As it turns out, the biggest advantage of a variable annuity, tax deferral, is actually a two-edged sword. The pro side is that you don’t get taxed on the return your money earns until you withdraw it. Within the variable annuity you may switch from one fund to another without incurring a capital gain. You can even switch variable annuity plans without being taxed (Section 1035 Exchange). Tax deferral is a tremendous advantage. Compared to an investment that had to pay all gains at ordinary income tax rates each year, the differences in total capital accumulation can be dramatic. You will often see comparisons like this in variable annuity literature. But that is not a full and fair comparison by any means.

All withdrawals from a variable annuity are subject to ordinary income tax. So variable annuity owners can never benefit from the lower capital gains tax that they might otherwise be eligible for in a mutual fund (or if they owned individual shares of stock).

If you owned a mutual fund which earned only 10 percent interest each year, you would have to pay taxes on the entire earnings. This is the worst case scenario. However, if you owned a fund that purchased stock, and that stock increased in value each year, you pay no tax until the stock is sold, and then you pay at the lower capital gains rate. You have had tax deferral, and benefited from the lower capital gains rate, too. If your fund never sells the shares — like an index fund might — you will have a far higher accumulation, and pay taxes only when you choose to sell your fund shares. In this case, the mutual fund or individual shares will have a far higher accumulation, after tax where it counts, than a variable annuity.

Most mutual funds fall between the two extremes of total annual taxation, or total deferral and capital gains treatment. So an analysis of the investment style and practices of the fund will have to be considered in any fair comparison. Funds with high turnover, or high levels of dividends or interest, will benefit proportionally more from a variable annuity.

There are two further tax complications: If you withdraw funds before age 59-1/2, you’ll pay a 10 percent penalty on top of the ordinary income tax. And, if you die before you get to take all the money out and spend it, a variable annuity is one of the only assets you might have which will not be adjusted for basis before passing on to your heirs. Variable annuities are subject to both estate tax and income tax, while an appreciated asset avoids the capital gains tax and is only subject to estate tax.

If that wasn’t bad enough, the wild cards are still out there. Nobody has any idea what “tax reform” will do to any of these assets. Proposals now being considered include a lower income tax rate, lower capital gains tax rate, a flat tax, and the abolition of the estate tax. Any or all of these will impact the value of a variable annuity when compared to other assets.

After age 59-1/2, you can withdraw money from a variable annuity in several ways: a lump sum, occasional withdrawals, or a stream of fixed or variable payments that lasts throughout your life (annuitization).

Unlike IRAs, you may continue to accumulate tax-deferred until age 85 before the government requires minimum distributions. This may fit well for retirees faced with “force outs” from IRA rollovers at age 70-1/2. Their variable annuities can continue accumulating tax deferred for an additional 15 years.

The annuitization payout gives you the most tax savings; part of each monthly payment is considered a return of your principal and not taxed. But this tax advantage is a very questionable benefit because most investors will not consider the option. Upon death, all capital balance in the account reverts to the insurance company.

If you take the money out in a lump sum or through occasional withdrawals, the payment(s) are treated as income first and principal second. So withdrawals are taxed fully until you start tapping into the principal. Remember, you have already paid tax on the initial contribution. One strategy you may consider is spreading your investment among several different companies. Then if you need money, liquidate an entire account — preferably the one with the smallest gain. In this case, you recover the entire initial investment tax free.

As a model for how that might work, consider the following two examples. First, $100,000 invested five years ago in a single variable annuity has grown to $150,000. You need $25,000 for an emergency. All of it will be taxable as ordinary income. Second, consider the case where the $100,000 was divided into five equal-size variable annuities or $20,000 each. Each is now worth $30,000. You liquidate $25,000 from one account. You have a taxable income of $10,000 and a return of your principal of $15,000. A far better result.

Cost of Variable Annuities

The next important issue a potential investor must consider before buying a variable annuity is cost. Actually, it’s a huge issue. But, in just another example of the capitalist system working to improve itself, investors are finally getting a break. Let’s look at the older (high-expense, large-commission) contracts first.

Investors should fully understand the three levels of costs in the variable annuity. It may not be easy to determine from the annuity prospectus. In fact, some variable annuities come with several prospectuses, one for the insurance company “wrapper” and one each for the underlying funds. This makes it even harder to figure out where the investor’s money is going, and how many people are going to share in it besides the investor. In spite of the high costs and high commissions, variable annuities have been marketed as “no-load”. This of course meant that instead of the commission being deducted up front, the contract was subject to a back-end surrender charge until the commissions and a healthy profit had been earned by all concerned. Many contracts have longer surrender periods, and higher amounts than even their mutual fund brothers. We might think of them as back-end surrender charges on steroids!

First there may be an annual contract expense, usually $25 to $35 per account. It is worth noting that small investments are adversely affected by the annual charge. Remember that $30 is a 3 percent annual fee on a $1000 investment, but only .03 percent on a $100,000. For that reason, you wouldn’t generally want to consider an investment below $10,000 if there is an annual expense charge.

Then there is a mortality and expense (M&E) charge by the insurance company, usually between 1.25 percent and 1.40 percent. In addition, M&E provides for the insurance company’s profit. If an agent was paid a commission on the sale of the contract, it is recovered here. Almost all variable annuities are sold with a back-end surrender charge instead of an initial sales load. The insurance company recoups their initial commission expense through higher annual charges. The back-end surrender charge goes away after a few years, but the annual charges continue forever.

An amazing number of variable annuities are rolled when the back-end surrender charge finally disappears. This generates an entirely new commission for the broker, and a new surrender period for the investor. Some new feature or investment option is always the rationale, but one has to wonder about the benefit to the investor.

Finally there are the expenses at the fund level. These charges are equivalent to mutual fund expense ratios and include management fees, expenses, and other investment costs. Often these expenses are higher than industry averages.

Total annual expenses can run between 2 percent and 5 percent, depending on both the M&E charges and expense ratios. These high costs could eat up any tax advantage that a variable annuity might produce. After all, we don’t expect the underlying investment to earn more just because it is inside an annuity. The market won’t know or care how high the expenses are.

Until very recently, there was little difference in contractual differences or costs between sponsors.

The real competition – such as it was – revolved around the quality of the investment managers, and the number of choices available within a single plan. Some of the world’s best known managers are represented in variable annuities. Some separate accounts are virtual “clones” of existing mutual funds. However, just to keep investors on their toes, others with the same name may be managed by different managers than their well known namesakes, and even with a different management style.

Costs and profits were very high in all variable annuities, and there was no incentive for any of the players to break ranks and give the investor a break.

Now, however, that log jam has been broken. If you are a do-it-yourselfer, Vanguard has a very low-cost “wrapper” for their investment funds. If you prefer working with an investment advisor, other companies have designed very economical products to accommodate you. These new products have stripped the M&E expenses to the bare bone, don’t pad the management fees in the separate accounts, and have no surrender fees. The total additional cost of a variable annuity over a no-load mutual fund now can run as low as 0.45 to 0.65 percent. While only a few are available today, more are certain to follow.

Variable Annuity Total Costs:


  • Annual Contract Fee (if any)
  • M & E
  • Separate Account Fees

Other Considerations:

When shopping for a variable annuity, treat the payout option as a minor feature. You can buy an annuity from one company and then switch to another when it comes time to start receiving payments. But, more than likely, you will never want to exercise this option. Having your capital confiscated by an insurance company at death is a neat solution to the pesky estate-tax problem, but not the one most of us would prefer. The additional income that might be generated by this arrangement hardly makes up for the lack of flexibility and loss of capital.

Financial Status of Insurer

Pay attention to the financial strength of the insurer, but don’t go overboard. One of the advantages of variable annuities is that the assets are held in a separate account, away from other claims. So far, variable annuity holders have not lost access to their money in cases when the insurer has been taken over by regulators. There is an important exception, though: Money in guaranteed interest accounts is commingled with the insurer’s other assets, so it’s at risk in case of insolvency.

Avoiding Probate

Variable annuities avoid probate by passing directly to a named beneficiary just like an insurance policy. This does NOT mean that an annuity avoids estate tax. Many arrangements for securities and other assets avoid probate. Check with a good estate planning attorney. By all means, consider your estate planning needs, but never let this one consideration drive your entire investment decision.

Creditor Proofing

Many states have made annuities and insurance contracts to be exempt under bankruptcy and/or make them very difficult for creditors to attach. As a result, professionals and others at high risk of litigation find them a good way to creditor-proof themselves. Again, consult with a specialist attorney if this is a consideration.

Minimum Death Benefit

Some annuities offer a minimum death benefit as a built-in feature. For instance, most guarantee that upon death, the beneficiary will never receive less than the adjusted contribution. Others will guarantee a return of (for example) six percent compounded, the initial contribution, or the net contract value, whichever is higher. (One of the great mysteries of life, is how insurance companies ever coined the phrase “death benefit”?) This minimum death benefit is a great deal less valuable than it may seem. Insurance companies cost it out at about 0.10 percent or less per year. However, knowing that their heirs can never receive less than the initial investment may make some cautious investors feel better about investing in equities.

Back-End Surrender Fees

Most variable annuities that pay a commission to a salesperson come complete with a back-end surrender fee. This back-end surrender fee tends to lock in investors who might otherwise wish to switch their managers or agents. A few new contracts offer a level commission option for the agent without a surrender fee to the investor. This is a far more investor friendly arrangement, and offers flexibility should the investor become dissatisfied with the agent, or the agent leave the business and “orphan” the investor. For what it is worth, I would never buy a contract with a back-end surrender fee now that alternatives exist.

Use In IRAs

Almost all the advantages of a variable annuity are already present in an IRA. IRAs already provide creditor proofing, tax deferral, and freedom from probate. So it is hard (just short of impossible) to make the argument that the additional expense is justified for IRA investments.

Is It Right For You?

How do you decide if a variable annuity is for you? Make sure that you have a strong rationale for buying a variable annuity, and bearing the additional costs involved.

Consider Variable Annuities If:

  • You have made the maximum tax deductible contribution to all of your tax-deferred retirement plans, such as IRAs, Keoghs or 401(k)s.
  • You’re in a high tax bracket.
  • You can lock in your money for a long time (at least 10 to 15 years).
  • You are willing to invest in high-return (high-risk) portfolios.
  • Your desired investment style would lead to high dividends, interest, and/or portfolio turnover.
  • You want to invest at least $10,000.

You can consider a variable annuity if you don’t meet all these requirements, but you should be much more cautious. Remember, due to the higher costs associated with variable annuities, you may come out behind alternative investments if all the above criteria are not met. Finally, future tax changes can screw up the best of computer models. So you might not want to jump off this cliff until your legislators give us some further direction on tax policy.


There is more than one way to skin a cat. To build an effective asset allocation plan we need building blocks with low cost, wide diversification, and a tightly targeted investment style. Closed-end funds, REITs, and UITs may be attractive alternatives to no-load funds for some investors, especially if purchased at attractive discounts. Wrap fee accounts are particularly attractive to the brokers who sell them. If Congress can ever resist the temptation to fiddle with the tax laws, we could all decide if the new variable annuity contracts have a place in our portfolios.

Coming up

In a perfect world, I could tell you that no-load funds, and all those who operate them, are pure as the driven snow. But, alas, mutual funds are not entirely exempt from all the less laudable practices of Wall Street. There remain important issues for regulators and investors. I’ll review the business practices and ethical landscape. Then I’ll suggest ways that by demanding better and voting with your feet, you can help further perfect the system.