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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 delaytaxation 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:
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.
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
retailtraders 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 assetpools 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.
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