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(ARA) - As tax time nears, many mutual fund investors are starting to wince. While most mutual funds' returns were down last year, their tax bill remains high.

After years under-performing the S&P 500, the average US stock mutual fund finally beat the index last year. But while the average fund was down just 0.37% v. the S&P 500's 9.1% drop, investors in the average fund actually lost around 3% when you add in the fees and capital gains taxes they must pay, says James O'Shaughnessy, CEO of Netfolio.com and author of the bestseller What Works on Wall Street.

"Mutual fund performance figures often leave out the taxes and some fees you are required to pay as an investor," says O'Shaughnessy, a former mutual fund manager and architect of a new investment service that eliminates the big drawbacks of mutual funds. "The little guy is left thinking he didn't do too badly when in fact he didn't do nearly as well as he thought."

Even the Securities and Exchange Commission is fed up. Just weeks ago, the SEC set new rules requiring mutual funds to disclose what they haven't disclosed for years -- the impact of income taxes on a fund's performance.

In the 1990s, investors all but overlooked their tax hit and the hidden costs in mutual fund investing. Strong and steady bull market fund returns made taxes a non-issue. But now, as investors gear up to pay taxes in April, many are discovering the inequity of paying high taxes on funds that declined in value.

How do taxes eat into fund returns? Let's say you invested $1,000 in the average mutual fund in January 2000. You would think that because the fund declined 0.37%, it left you with about $996 in December. Not too bad, you say, it could have been worse.

But not so fast. Throughout the year, the manager of the average mutual fund commonly sells 92% of his fund's stocks in an attempt to boost returns. Who pays the capital gains taxes on his giddy trading activity? You do. In fact, you'll have to pay a higher, short-term tax rate on the gains from assets the manger held for less than a year.

That means you'll have to use your income tax bracket to calculate your bill rather than the lower 20% rate charged on long-term gains. Your tax rate on these gains could be as high as 50% after you add up the your federal, state and local tax rates.

But taxes are only half the story. The typical mutual fund also charges annual fees, an expense ratio it uses to pay the fund manager, and transaction costs it uses to pay the fund's brokerage expenses.

Now let's revisit that $1,000 you invested in the average mutual fund last January. By December, you would have paid about $18 in fees and about $12 in capital gains taxes. So you lost about $30 on your $1,000 investment, not $3.70. That's about a 3% decline rather than the 0.37% drop reported recently by fund-tracking firm Lipper Inc. The 0.37% decline is the gross return of the average US stock fund and does not include taxes or fees.

"Mutual fund investors should be offended by the amount of taxes and fees they have to pay," says O'Shaughnessy. "Mutual funds may seem like no-brainer investments but they can compromise your long-term savings potential. All the money you spend on fees and short-term capital gains taxes could have remained invested and compounding."

O'Shaughnessy has identified five big mutual fund drawbacks:

1. High expense ratios. Investors pay a fee for the privilege of owning shares. That fee goes to the fund's manager. But instead of a flat amount, the fee is based on your assets in the fund. The more money you have invested, the higher your fee.

2. Undisclosed transaction costs. This is the fee that a mutual fund pays to its broker to buy and sell stocks. The fee is not found in a fund's prospectus and is deducted from the fund's returns. The higher the fund's portfolio turnover rate, the higher its transaction costs.

3. No control. You have no say over what stocks the fund owns. Some stocks may be ideal for you while others are not.

4. Little knowledge. Because you don't know what specific assets a mutual fund owns on a daily basis, you could wind up owning the same stocks in several different funds. Or the types of stocks the fund buys now may differ from the ones it set out to buy when you originally invested.

5. Significant tax hits. In addition to the capital gains taxes you pay when your fund manager actively trades stocks, you also face "embedded capital gains." These can occur when a fund you recently bought sells a stock it has held for many years. Your tax hit on that trade will be equal to someone who has the same amount invested but owned the fund for many years and profited from that stock's long run-up in price.

What's the average mutual fund investor to do? Alternatives are emerging that provide individuals with more control over their investments and taxes. The Web-based services in this new "personal fund" sector offer stock portfolios that are tailored to an individual investor's personal financial goals.

Instead of buying mutual fund shares, investors in personal funds buy an entire portfolio of stocks for a relatively low minimum investment. By owning the stocks in a personal fund, you control your capital gains taxes by choosing when to buy and sell stocks. You also know at all times the stocks you own.

The low cost of ownership and individual control of tax responsibilities offer individuals significant advantages over mutual funds and other popular investment vehicles. As such, Forrester Research, an e-commerce research firm in Cambridge, Mass., predicted that more than $1 trillion will be invested in personalized funds rather than mutual funds over the next 10 years.

"The days when mutual fund investors have to eat what they are served are over," says O'Shaughnessy of Netfolio.com. "Personal funds make it possible for every individual investor to own a professionally selected stock portfolio that is reasonably priced and designed for their needs and goals."

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Netfolio.com is one of several new services offering individual investors personalized fund portfolios and -- surprise -- the first headed by a former mutual fund manager.

To begin investing at Netfolio, you pay $200 a year or $20 a month to subscribe to its service. Then you open a Bear Stearns account online at the Netfolio site at no additional cost.

To invest, you ask Netfolio to recommend personal funds that suit your investment objectives. Or you can pick them on your own from Netfolio's list. Each personal fund comes with a recommended stock portfolio that you can customize prior to investment.

You can buy an entire portfolio of stocks in a personal fund with a minimum investment of just $5,000. And there are no commissions when you invest in Netfolio's personal funds online through Bear Stearns.

"This type of personalized investment advice used to be available only to the superwealthy," O'Shaughnessy says. "Now, thanks to the Internet, individual investors everywhere can access the same type of service through their computer."

About The Author

Courtesy ARA Content, www.ARAcontent.com; e-mail: info@ARAcontent.com

This article was posted on January 17, 2002some content courtesy ArticleCity.com

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