The Taxman Says, Don't Trade!

Under Deliberation I am considering a trade. In spring 2016, I swapped company stock for two energy-pipeline funds, Alerian MLP AMLP (an exchange-traded fund) and ClearBridge Energy MLP Opportunity EMO (a closed-end fund). The deal, discussed briefly at the conclusion of this column, involved 5% of my portfolio, split evenly between the two funds. I am now considering selling those positions.

My thoughts at the time were as follows:

1) Energy stocks had performed terribly, because oil and gas prices were at 15-year lows.

2) Over the very long term, the prices of essential commodities tend to mean-revert. Those at the high end of their historic ranges will likely fall, and those at the low end will probably rise.

3) Thus, energy seemed like a good short-term trade for the "explore" section of a portfolio, with the caveat that a wager on commodity prices, even in the most general fashion, is far from a certainty.

4) Because the bet was relatively uncertain, even by investment standards, be conservative. Make a chicken bet by buying the sector's dawdlers: diversified pipeline funds.

Good Fortune As you can see, the analysis wasn't deep. In my experience, contrarian investments require action, not introspection. Their news is bad, the forecasts dire. If I research contrarian ideas thoroughly, I will find reasons not to buy. Better to have a simple but irrefutable thesis--such as, commodities do tend to mean revert, and this commodity is selling at an usually low price--and just do it.

My security selection was also simple. Again, I have learned from experience not to dither. I look at this, I look at that, and then the opportunity passes. Find something reasonable and place the order. After all, these aren't core holdings to be held for decades (as with my first fund, which I have owned for 28 years now). My friend who works in the pipeline business suggested several funds; I looked up the Morningstar reports (naturally!) and bought those two.

At any rate, fortune obliged. Not only have energy prices overall rallied, but pipeline master limited partnerships have been helped by President Trump's executive orders. Of course, I expected no such assistance when buying those funds. But such is the nature of luck, it cuts both ways--it took down pipeline companies in winter 2016, and it raises them up today.

Which tells me that it's time to sell. My pipeline assets have gained 21% annualized since their purchase date (March 30, 2016), which is only slightly behind that of the S&P 500. As pipeline funds are diversifiers that often zig when other stocks zag and almost never keep pace with a raging bull market, that rates as a success. As of course are the funds' absolute returns, in today's low-inflation environment. (In recent years, it has been almost impossible to go wrong while owning stocks, and almost impossible to keep up with equities by holding anything else.)

Uncle Sam Calls But here's the thing: taxes. These funds are in a taxable account. They currently are worth 37% more than their cost basis (don't try to reconcile that number with the total-return figure from the previous paragraph, because tax accounting for MLP funds is tricky indeed). In my tax bracket, that means an 8.8% tax bill.

(Many investors will have a lower tax bracket, at 15%, which would lead to a 5.6% tax payment. Nonetheless, even at that reduced level, this column's point remains.)

Wait. What? As with all informed shareholders these days, I closely watch costs. Most of my portfolio is in directly held stocks rather than funds; most of those fund assets are indexed; and aside from the two pipeline funds, the active funds are cheap. The portfolio's expense ratio is 0.08% per year--8 basis points. And now we're talking almost 9%, amortized over 22 months?

The Fear Factor That potential tax bill gives me pause. It is why I am merely considering the trade, rather than making it. It also has made me realize how inconsistently investors treat costs. The same people who refuse to pay almost anything for brokerage commissions, and who purchase one index fund rather than another because of a tiny difference in annual expenses, will casually make trades that cost them 500 basis points in taxes. If investors were as loath to pay taxes as they are brokerage commissions or fund expenses, they wouldn't sell any winners in their taxable accounts, unless they could offset them with losers. Yet they do.

The discrepancy between how people view investment costs and how they regard tax costs doesn't make sense. For good reason, fund investors are highly skeptical of professional investment managers' claims. Most pros cannot succeed at a high enough rate to overcome even the modest hurdle of their funds' expenses, and the transaction cost of making the trade. Meanwhile, the same investors who scoff at active managers' abilities are confident that when they generate a tax bill, it is because they have made the correct investment decision. That is inconsistent, to put the matter mildly.

By weighing the investment decision more heavily than the tax decision, investors refuse to "let the tax tail wag the dog," as the adage goes. The defense for such an approach is that it's better to buy a winner and pay a penalty than to hold a loser. Except, of course, we don't know that taking action means buying a winner, and we don't know that standing pat means holding a loser. That is sheer guesswork. The only certainty is the tax bill.

Such is my current position. I can harvest my profits and move on (perhaps by re-investing in shopping mall REITs, as they are suitably unpopular). Or I can postpone my tax reckoning by keeping the bird that I currently own. My instincts urge the former, my head the latter.

What would you do?

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.