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ETFs Ease Tax Headaches and & Are More Efficient Than Mutual Funds

By: , dated January 25th, 2013

Almost nine out of every ten investors have some kind of a mutual fund in their portfolio. These ever popular investment tools are loved for their steady, reasonable rates of return and low risk thanks to diversification. However, many investors hate the high management fees and expenses charged by actively managed mutual funds. However, while these fees and expenses diminish investment performance, they may not affect overall returns as much as the decisions of the portfolio manager – or the holders of the mutual fund themselves!

The portfolio manager for a mutual fund is paid to outperform a benchmark, like the NASDAQ 100 index. To accomplish this, portfolio managers will sell off the losing stocks and look for winning stocks to buy. This leads to high turnover and increases the expenses associated with maintaining the mutual fund.

Another factor that leads to increased turnover in mutual funds is the redemption requests. At any time (although there is usually a “redemption fee” assessed), an investor may produce a redemption request and remove assets from their account. If there are a lot of redemption requests made in a short period of time (like after a major stock in the index just tanked due to a bad earnings report), the mutual fund may not have enough cash on hand to honor all the requests. When this happens, the portfolio manager will have to sell off assets from the mutual fund. If any of these assets realized any capital gains, those gains must be distributed to the owners of the mutual fund based upon their percentage of ownership. Owners of the mutual fund have no choice but to declare the capital gains in their tax returns. This means that the actions of individual mutual fund owners can impact the tax liability of all mutual fund owners. This is why mutual funds are not considered to be very tax efficient. During the second half of the 90′s, it is estimated that 15% of all annual gains achieved by mutual funds during this period were eaten up by taxes.

ETFs are far more tax efficient than mutual funds but many investors don’t understand why. An investment tool is considered to be more tax efficient the longer it can delay taxation on appreciating assets. This is because by delaying paying capital gains today, that money that would have been spent on taxes can then accumulate more wealth. The overall percentage of capital gains paid in taxes will decrease over time. The amount that can be saved depends upon three factors:

1. Rate of return on investment

2. Time of delay between realizing capital gain and declaring it for tax purposes

3. Marginal tax rate

ETFs are more tax efficient because the actions of individual investors do not affect the tax burdens of other investors. This is possible because of the way ETFs are constructed.

ETFs are created by large financial institutions such as Vanguard or Merrill Lynch. One of these financial companies may want to create an ETF that mirrors an index tracking the S&P 500. Rather than put up any cash, the institution may choose to put up a portfolio filled with stocks from companies in the S&P 500 index. The portfolio is held as collateral and in exchange the company establishes one ETF unit.

Each ETF unit can then be further divided into shares that can be created and redeemed according to the dynamics of supply and demand. The shares are created and redeemed by the financial institution that created the ETF. This all happens thru non-taxable transactions made possible by the portfolio of actual stocks that the financial institution put up as backing for the ETF. Since no cash actually changes hands in the process of creation/redemption, the individual transactions of retail traders are not taxable until the investor sells his/her holdings in the ETF.

What all this means is that the actions of individual ETF investors will not affect the tax liability of other traders. There are no taxable transactions that take place at the fund level so the IRS has nothing to worry about. This helps investors delay paying taxes on gains until the holdings are sold, thus making ETFs more tax efficient than mutual funds.

ETFs are also useful for tax minimizing purposes and there are two basic options available to investors: “Swapping” and “Substituting.”

Sometimes, it is just necessary to realize a loss for the “tax man.” Effective tax planning requires investors to offset capital gains whenever possible. Using losses to offset current and future capital gains becomes more important the larger a portfolio becomes because larger asset pools can build wealth quicker than smaller ones. Not only can losses from ETFs be used to offset capital gains, they can be used against a small portion of income as well.

When swapping, an investor typically sells one ETF for a loss and then turns around and buys a similar ETF. The loss can be applied against any current capital gains or saved for future gains. This may appear to violate the “wash sale” rule at first glance.

The “wash sale” rule basically states that an investor cannot claim a loss for tax reasons if a substantially similar security is purchased within 31 days of sale. However, so long as the ETFs were comprised of different securities with substantially different rates of return, then the securities would not be considered substantially similar. Instead of swapping one ETF for another, an investor can also minimize tax burdens by substituting an ETF for another type of security. So if an investor took a beating on a biotech stock this year but made a killing in another sector, the biotech stock could be sold for a loss and an ETF tracking the biotech sector could be purchased to take its place. Swapping is perfectly legal and can help minimize tax burdens by delaying gains until the ETF holdings are liquidated.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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