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Here's a statement of the obvious: The opinions expressed here are those of the participants, not those of the Mutual Fund Observer. We cannot vouch for the accuracy or appropriateness of any of it, though we do encourage civility and good humor.

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  • Since the early 1990s, index-based investing, also known as passive investing, has been quite popular amongst investors looking to mirror an index and copy the market returns for an individual portfolio.

    Seems a bit tautological (except for the 1990s part). Investors who want to mirror an index are virtually by definition interested in index-based investing.

    the important fact to keep in mind is active portfolio fees, i.e. 12b-1 fees ...

    12b-1 fees are servicing/marketing fees that have nothing to do with the management of a fund. For example, index funds such as GBIAX and TBILX have 12b-1 fees.

    The whole purpose of an active strategy is to beat market returns and present an added value for active investors.

    Some actively managed funds seek to reduce volatility and don't even try to match the market let alone beat it.

    VMVFX: While the fund’s goal is to limit the volatility of global stock investing, we caution against expecting any low or minimum volatility investment to outperform, or even match, the global equity market over the long term.

    In municipal debt funds, comparatively, there aren’t many variables other than interest rate risk and credit risk to justify the active management fees for municipal debt portfolios.

    Pre-refunded, callable, subject to extraordinary redemption, GO vs. revenue, sector selection (some affected by local demographics), AMT exposure, geographic concentration risk, etc.

    A given bond, with given attributes, can on average be expected to behave a certain way. IMHO a bond is a very mathematical type of security. (So if you diversify away issue selection risk, with bonds you have a very good idea of what to expect.) That's a far cry from saying that the only attributes that affect a fund's returns are credit risk and interest rate risk.
  • There’s a huge risk in the room with muni bonds: at any moment Congress or the president could decide to make their interest taxable. There has been talk about this in the past few years. I used to think muni bond income would be a significant part of my income in my dotage, but not anymore
  • The idea that the president could make munis taxable is dubious at best. The executive branch (including the IRS) generally, and the president specifically, can change regulations and policies only to the extent that the changes remain consistent (do not contradict) existing laws.

    The Internal Revenue Code, section 103 states succinctly that with three exceptions (in 103(b)), interest paid on state and local bonds must not be taxed.

    Congress certainly has the power to pass legislation making some or all muni bonds taxable. It did this in creating Build America Bonds. Congress enacted Section 54AA of the IRC, which says that if not for Section 54AA, the bonds would be tax exempt under IRC 103, as described above. That is, BAB bonds are, by a specific law, not tax-exempt.

    It would take an act of Congress to make muni bonds generally taxable. The president cannot do this by fiat.

    From a strictly pragmatic perspective, Congress is barely able to pass appropriations bills before the government again runs out of money in a couple of weeks. And this is the legislative body you fear will proactively take away the tax-exempt status of muni bonds?

    Even if, against all odds, Congress did come together and pass some such bill, what would it look like? Would it revoke the tax-exempt status of current muni bonds> Or would the possibility that such a change might be unconstitutional prod Congress into taxing only bonds issued in the future (as was done with advance refunding)?

    If so, then what do you see as the risk to currently outstanding munis? ISTM that by preserving their tax exempt status but drying up the supply of future tax-exempt munis, Congress might make current munis even more valuable. A double win for current bond holders - tax exempt interest and capital appreciation. As an investor, I wouldn't mind getting stomped on by that elephant.

    As a taxpayer, the prospect of having to pay 40% more to get infrastructure does not please me. But that's a different matter altogether.

  • edited December 2019
    It doesn't make any sense for congress or the president, even if they could, to change the tax exempt laws for Muni-bonds. Municipal projects always need funding for infrastructure and social needs, or society to an extent falls apart. Tax exempt status assures people, mainly higher income people, will continue to invest.
  • I have a question, and maybe @msf you know the answer, but I've always heard muni bonds are better suited for a taxable account. My question is, doesn't a mutual fund get tax exemption returns for holding muni's also? And in turn those mutual funds held in a tax-deferred account get the tax exempt return passed on to them, us?

    I've held a muni ETF for a couple years now in my IRA, PZA. I've often wondered if the tax exemption is part of total return.
  • edited December 2019
    +2 MikeM

    Not going to happen.
  • It only makes sense to hold a muni in an IRA is when you expect its total yield (cap gain plus interest) to exceed the total return of a taxable bond. That's because coming out of the IRA, both are taxed the same way. So which ever one wins on gross income also wins on net (after tax) income.

    Say your tax bracket is 1/3 (33%). Consider three investments:
    - A muni bond paying 2%
    - A treasury bond paying 3%
    - A utility stock that doesn't appreciate but pays qualified divs of 2.35%

    In a taxable account, they'd all yield 2% after tax:
    - The muni's 2% is tax-free
    - The treasury gets taxed at 1/3, leaving 2/3 x 3% = 2%
    - The stock div gets taxed at 15%, leaving 85% x 2.35% = 2%

    In an IRA, all money coming out is treated as ordinary income (taxed 1/3):
    - The muni earnings, taxed at 1/3, are reduced to 2/3 x 2% = 1⅓%
    - The treasury earnings again taxed down to 2%
    - The stock divs, no longer treated as qualified, are reduced to 2/3 x 2.35% = 1.57%.
  • Thanks @msf, but not sure that answered my question. Maybe I didn't state it properly.

    I'm not talking about what I pay for taxes when i withdraw the money from a tax defered account. I'm talking about the total return growth of the mutual fund if the fund is getting yield tax free.

    I've heard that there are tax efficient mutual funds so on the other hand there must be less efficient funds. A regular bond mutual fund (say a corporate bond fund) pays taxes on their gains when they sell or when the individual bond matures inside the fund, is that correct? That tax, I would guess, is subtracted from total return. So if a mutual fund is holding a tax free bond I would assume the profit on that tax free bond is tax free for the fund. Wouldn't that, the fund not paying tax on the muni bond yield, increase total return of that muni bond fund?
  • You are correct that funds subtract expenses before paying you a div. But they generally don't pay US or state income taxes on their earnings. Instead, they pass that income through to you, so you alone pay the taxes.

    As Fidelity explains: "funds that have net gains from the sale of securities or earn dividends and interest from securities they hold must pass the largest possible portion of those earnings on to its shareholders or those gains will be subject to corporate income taxes and excise taxes. These taxes would, in effect, reduce your total return."

    What tax efficient can mean for a mutual fund is that it doesn't generate (much) income, so it passes almost no income to you to be taxed. For example, it may own non-div paying stocks that simply appreciate. And it may also avoid cap gains by harvesting tax losses or simply not trading much.

    With these tax efficient funds you don't get much in the way of divs. Instead, their NAVs go up over time. You don't owe taxes until you sell your fund shares and realize a cap gain.

    Muni bond funds are said to be tax efficient as well. Not because they don't generate income that they pass through to you, but because that income that is passed through is tax-exempt.
  • edited December 2019
    When is the last time Congress enacted a law which imposed a higher tax burden on the upper 10% while reducing the overall tax bite for low and middle income wage earners?
  • It doesn't exactly fit your parameters, but the ACA comes close. Medicare surtaxes of 0.9% on wages above $200K (single)/$250K (MFJ) and 3.8% on net investment income above those levels. Simultaneously, the ACA provided for tax credits (aka Obamacare subsidies) for low and middle income wage earners.
  • edited December 2019
    Point taken @msf. And we know what happened to the ACA. The following numbers are a bit dated (2013), but I think they’re still relatively valid today and serve to make my point:

    “ A smaller fraction of Americans owns state and local government bonds today than 25 years ago (2.4% in 2013 vs. 4.6% in 1989), and that ownership is more heavily concentrated among the very rich (the top 0.5% of Americans by wealth held 42.0% of all municipal bonds in 2013 vs. 23.8% in 1989) ...” .

    The substantial majority of hired-guns occupying Senate seats have no incentive to take away the tax break on munis - or remove the tax-free status of Roths, for that matter. Many would disown their own mother first. Some day, after enough jello hits the fan, the tune might change - but not in the foreseeable future.
  • " And we know what happened to the ACA"

    I wonder. Every time I look at provisions of the ACA, I go, oh yeah, I'd forgotten about that. For example, the tax on insurers. No one knows what's going on with that:
    The health insurance tax was in effect from 2014 through 2016. Congress approved a one-year moratorium for 2017, and the tax resumed in 2018 at a cost of about $14.3 billion. Congress suspended the tax once again in 2019. If not further delayed, it will be collected again beginning in 2020.

    Regarding who owns munis: Munis were never great investments for much of the middle class. Most of the time, if you were below the 31% tax bracket, you'd have been better off investing in taxable bonds. This is reflected in the statistic that even 30 years ago (1989) fewer than 1 in 20 owned munis.

    Rational middle class investors have been getting pushed further out of munis for a long time. Obama made the Bush tax cuts permanent for the middle and lower classes, making munis less attractive. Then the GOP moved even more middle class taxpayers into a 24% or below tax bracket (ordinary taxable income below $160K [single] / $321K [MFJ]).

    One can't have it both ways - advocating lower middle class marginal rates and simultaneously bemoaning the fact that munis consequently become less attractive. So long as taxpayers in the highest brackets keep buying munis, states will continue to be able to borrow at lower rates and fund needed work on century-old infrastructure systems.
    pipes can range from 15 to 100 years old depending on conditions, although some older northeastern cities operate with pipes that are 200 years old.
    America's Aging Water Infrastructure
  • Umm ... my point was that Congress won’t mess with munis precisely because on average they benefit wealthy individuals more than middle and lower income individuals. I’m not opposed to them. @msf has everything here correct I think. I’m just trying to allay fears by some in the discussion that the tax exemption for munis will be abolished.
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