Can “ETFs” Make You A More Tax-Efficient Investor?
Back in the good old investing days of the 1990's, some investors quit worrying about details like fund expenses and taxes. After all, when your index funds are racking up 20+% gains for five years in a row, why sweat the small stuff? But today's investing climate is different, and with many prominent investing professionals predicting stock gains of just 5-7% annually over the next several years, attention to detail is coming back in style.
While the costs associated with management fees and sales loads are "on the radar" of most investors, some fail to account for the "cost" of taxes. This happens despite the fact that many investors have a mixture of non-taxable and taxable accounts. Yet taxes reduce the average mutual fund return by 2.5 percentage points annually. It doesn't take a math wizard to see that a 5-7% gross return would look mighty puny if cut nearly in half by taxes.
If you have a taxable account and are trying to minimize Uncle Sam's take on your stock market gains, there are three primary tools at your disposal: index funds, tax-managed funds, and the "exchange traded funds" (or ETFs). Here's a brief review of each to help you determine which tools might be right for your situation.
Index funds are tax-efficient by the very nature of what they do. Buying and holding the stocks of an essentially static index is certainly a good way to minimize trading costs and capital gains. Truth-be-told, there's a lot of overlap between tax-managed funds and index funds, as many tax-managed funds are really little more than index funds optimized to minimize taxes even further.
For example, Vanguard's Tax-Managed Growth and Income fund generally mimics the S&P 500 Index, and in fact, is run by the same manager as Vanguard's better known 500 Index fund. The primary difference is that Tax-Managed Growth is run with an even more aggressive emphasis on minimizing taxes, which in this case has typically resulted in tax-adjusted annual returns about 0.2-0.3% better. Not a huge improvement, but if your style preference is for indexing over active management anyway, it makes sense to check if there's a tax-managed fund tracking the same index you want to follow. Even 0.2% per year adds up over multiple years.
Tax-managed funds typically utilize the following techniques to minimize their tax exposure:
• They limit their buying and selling. The ultimate practitioners of this are index funds. (That's why SMI's Just-the-Basics strategy tends to be tax-efficient.) Not surprisingly, many tax-managed funds mimic a category index. But there are also actively-managed funds available that reduce their tax bill by keeping portfolio turnover low.
• They buy low-dividend, high-growth stocks. Dividends are taxable at the investor's marginal tax rate, so they are less attractive than the capital gains that growth stocks generate. Even tax-managed funds that mimic an index will often favor stocks within the index that pay no or low dividends.
• They postpone selling. In order to achieve a one-year holding period (and thus qualify for favorable long-term capital gain rates), they sometimes delay selling stocks in which they have gains.
• They sell their most costly shares first. "HIFO" accounting (highest in, first out) is used by most tax-efficient managers. This technique requires that when shares are sold, the highest cost shares are designated as being sold first. This minimizes taxable gains without affecting pre-tax returns.
• They take losses strategically. Tax-efficient managers are usually quicker to sell at a loss, as they view losses as an asset to be used to neutralize taxable gains. Such an approach is called "harvesting" their losses. By engaging in intelligent tax-loss selling, good managers can minimize capital gain distributions.
• They penalize short-term traders. Unexpected redemptions can force a fund manager to sell stocks prematurely to cover the liquidations. This can work against their tax-minimizing strategies. To reduce such pressures, some funds assess a redemption fee on investors who sell shares held less than a certain length of time. Vanguard's tax-managed funds charge a 1% fee on the sale of fund shares held less than five years.
EXCHANGE TRADED FUNDS
The newest entrants into the tax-efficient arena are ETFs. They offer a convenient way to invest in a pre-assembled basket of stocks, like those in a particular index or sector of the economy. While they have advantages over actively-managed mutual funds in terms of trading flexibility and lower expenses, when compared to index funds, those advantages aren't very significant for most investors. It's also true that ETFs can be more tax efficient even than index funds. That makes sense, as they are bought and sold like individual stocks (with the associated brokerage costs). This means you are in control of all buy/sell decisions, other than the occasional changes to the underlying group of stocks your ETF tracks. In addition, capital gain distributions should be even more rare and for smaller amounts than with index funds.
In reality though, the tax advantages of ETFs over index funds are pretty slim in real dollars, unless your account balance is at least six figures. Some would argue that most existing index funds already have large capital gains built up in them as a function of how they're run. While that's never been a problem before, it is true that if mass redemptions ever did force index funds to dump shares, it could result in a tax problem that ETFs would avoid. For most people though, any tax advantage of ETFs is going to be more than offset by the transaction costs of purchasing shares, a particularly important point for those employing a periodic investing or dollar-cost-averaging strategy. On the other hand, if you want to invest in an area of the market that doesn't have a good index or tax-managed fund associated with it, an ETF focused on that market segment may be an excellent choice. ETFs still compare very favorably with most actively-managed mutual funds on an after-tax basis.
The best tax-efficient choice for you will largely be determined by your active-management vs. indexing preference. If you prefer indexing, select the index you wish to follow, then compare the pure index funds that follow it vs. the tax-managed funds that also follow, albeit perhaps slightly less rigidly, the same index. You'll often find good choices in both camps, with the possibility of squeaking out some extra tenths of a percent out of the tax-managed funds. And finally, for those looking for tax-advantaged exposure to certain market segments not served well by current index or tax-managed funds, ETFs can offer a measure of tax relief. Keep an eye on them over the next few years, as innovative additions continue to expand the ETF market.
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