Insights & Advice

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ETFs are Tax Efficient

Capital Gains Distributions hurts your real returns

Tax time is drawing closer and as it does, the annual barrage of questions concerning investments, portfolios, dividends and distributions are keeping financial advisors and accountants quite busy.

“One of the most frustrating issues to me,” writes a Long Island investor, I’ll call Joey G., “are the mutual fund capital gain distributions.”

As a large holder of mutual funds, every year, between November and December, Joey is hit with substantial taxable capital gain distributions from the mutual funds he owns.

“I have no idea how much they are going to be or when they are going to be distributed until its too late, so there’s no way I can plan for them tax-wise.”

Joey G. is not alone in voicing this complaint. For readers who are not familiar with mutual funds capital gains distributions, it works like this. During the year, mutual fund manager try to buy stocks low and sell those same stocks at higher prices generating capital gains, the more successful the manager the higher the capital gains. That’s the good news.

The bad news is that the fund manager then passes on all these taxable gains to the holder of the fund, in this case Joey G., for example, depending upon the size of your holdings, this tax bill can be many thousands of dollars. To some this may seem to be a luxury problem since the higher the gains, the higher should be the appreciation in the price of the fund but not always.

There are years such as 2008, when, as the market declined, fund mangers sold stocks they had held for a long time. Those sales generated huge capital gain distributions for their investors. At the same time, because the markets were declining, investors sold out of mutual funds in great numbers sending the price of mutual funds to multi-year lows.

“Not only did I have to pay a huge tax bill that year,” laments Joey G., “but the very same mutual funds that gave me this tax bill were now selling at deep discounts to my purchase price.”

For those who are tired of these capital gains issues, I would suggest looking at exchange-traded funds or ETFs. Since they are index funds, once their indexes are created it rarely change (no need to buy or sell) so there are relatively few, if any, capital gains distributions.

On occasion there may be a gain (or loss) generated but only if the underlying index the ETF tracks changes in composition. For example, if you purchased the SPDR S&P 500 (SPY), that ETF tracks the performance of the S&P 500 Index. If at some point the S&P were to replace one or more stocks in the index, the ETF manager of SPY would also do the same. In that case, there could be a gain or loss (and a distribution) in the ETF. Those kinds of changes occur infrequently.

There are exceptions to this rule; however, since not all exchange traded funds are created equal. There are some “black box” ETFs that are actively managed. Their marketing managers claim that because of their internal strategies, their ETF can out perform whatever index they represent. Sticking with the S&P 500 example, the actively-managed ETF might only select a sub-set of the Index, or buy and sell various stocks within the index, in an effort to provide outperformance. The results of these black box beauties are checkered at best. To me, these hybrids rarely fulfill their promise while their expense ratios are higher than plain vanilla ETFs and there can be capital gain distributions as well.

Since over 75% of mutual fund managers fail to outperform the indexes anyway, ETFs make sense on the performance side as well. They are cheaper to own, the tax advantages are clear and when next you compare an ETf to a mutual fund remember that the mutual fund performance does not include the taxable consequences of capital gain distributions.

Posted in A Few Dollars More, Portfolio Advice