Many investors know that an exchange-traded fund or ETF structure is generally more tax efficient than a traditional mutual fund, but this year’s carnage in bonds has prompted action. In October, it released more than $450 billion in bond funds for investment company Institute. During that period, $157 billion went into bond ETFs, like bundle swaps, maintaining exposure to the bond market but seeking a more tax-friendly vehicle.
For many mutual fund owners in non-retirement accounts, December brought a nasty surprise: double-digit losses on taxable capital gains distributions. For those looking for broad stock and bond exposure, the ETF structure offers some advantages for tax-conscious investors.
For starters, most ETFs are passive, designed to track an equity index like the S&P 500 or a bond benchmark like the Bloomberg Aggregate Bond Index. Transactions in an index ETF occur only when constituents in the underlying index change, a relatively rare event. Most traditional mutual funds, on the other hand, are actively managed and execute hundreds of trades a year. More trading means more trading costs and higher fees, which is important because few active funds beat passive indexes over time, despite the tax implications. Many researchers have shown a correlation between high turnover and low returns.
Most importantly, when a fund sells a security, it must recognize the gain or loss on the position that is passed on to its holders at least annually. Typically an actively managed US equity mutual fund has a turnover ratio of more than 50%, meaning that about half of its holdings are sold within a year, creating taxable events for holders. Some equity funds carry a turnover ratio of over 1,000%. Meanwhile, passive equity index ETFs rarely exceed 5 percent.
Low exchange rates and expenses are beneficial to investors in tax-deferred and retirement accounts, which increase net compounded returns over time. But by far the biggest reason to favor ETFs from a tax perspective is the fundamental difference in the structure of exchange-traded funds and mutual funds.
Traditional mutual funds, known as “open end” funds, do not actively trade in the stock or bond markets. Each day, as the fund receives cash flows from new investors, it creates new shares representing the corresponding interest in the pool, and invests the cash received into the underlying portfolio. The currency is calculated daily by adding the individual prices of all holdings after the markets close. That sum is called the “Net Asset Value” and is calculated daily. So far so good.
What if the holders want money? The fund must then sell enough of the portfolio to collect the funds, realizing a gain or loss on the positions sold. During the year these profits and losses are accumulated and at the end of the year they are still distributed to the outstanding shareholders. In the year Hard redemptions in 2022 will require forced sales, often of long-term gainful securities. In most cases, residual owners received a capital gains tax Christmas gift even though their money was underwater for the year.
Shares ETFs represent a fractional interest in a portfolio but are very diverse in structure. Shares are created by banks based on demand in the market and are not created and destroyed daily as redemption. Instead, investors buy and sell ETF shares throughout the trading day just like individual stocks. Capital gains or losses occur when ETF shares are sold and, like common stocks, depend on the price of the shares and the holding period. Generally, year-end dividend distributions are smaller in an index ETF, and the investor has more control over whether (or when) to pay taxes.
2022 provides a unique opportunity for taxable bond mutual fund investors to offset capital gains distributions by pooling capital losses and converting rolls into a similar ETF structure, as long as the two funds are not too similar.
An important caveat applies. The discussion here applies to passive index ETF strategies, but there are a growing number of actively managed exchanges that have greater exposure to tax spreads. Some precious metals ETFs that offer exposure to gold and silver are treated as withholding tax and subject to a higher tax rate. Many commodity ETFs are structured as limited partnerships and generate a K-1, which can complicate tax filing. Commodity funds use futures contracts and can spread gains and losses as contracts expire and are replaced. And some critters that look like ETFs are actually a form of bond that exposes the investor to the credit risk of the issuing bank. These products are called Exchange Traded Notes or ETNs and should generally be avoided unless you understand the risks well.
The universe of exchange-traded funds has expanded dramatically, and for average investors seeking exposure to diversified stock and bond market returns, an ETF structure can provide better net returns and less pain at tax time.
Christopher A. Hopkins is a chartered financial analyst and founder of Apogee Wealth Advisors.