OT:Investing in Exchange-Traded Funds: Big Tax Benefits
David W. Cowles, CPA, CFP
Mosaic Financial Partners
he use of exchange-traded funds (ETFs) is soaring. Just five years ago, there were only about 35 ETFs. Now, there are more than 300, representing many types of securities, so investors can put together a diversified portfolio of ETFs. Or ETFs may be used to fill out a portfolio that includes other more traditional investments.
While there are several reasons for their increasing popularity, including low expense ratios, tax benefits are among the advantages of ETFs that are most prized by investors.
ETFs hold a number of different securities, providing diversification. Unlike mutual funds, though, ETFs trade on exchanges like stocks. An ETF will have an initial public offering of shares and perhaps some secondary offerings. Subsequently, those shares trade among investors through brokers, rather than with the fund company.
Each ETF is designed to track a particular index. It might be a stock market index, such as the S&P 500, or a less familiar index tracking intermediate-term bonds, or an assortment of real estate securities, for example.
Taming Turnover
Like index funds, ETFs are naturally tax efficient.
Key: An ETF generally holds the stocks or bonds that make up a particular index. The components of indexes rarely change. Thus, ETFs seldom sell securities. They're true buy-and-hold vehicles.
Advantage: Unlike mutual funds, ETFs usually do not have trading gains. In some years, trading gains have created huge tax headaches for mutual fund investors, but ETF holders have not had this problem.
Example: You invest in a successful mutual fund. A month later, the manager decides to take profits on oil stocks and move into utilities.
Your share of the oil-stock profits will be passed through to you, even though you were not a shareholder while those profits were made. Some of these profits may be short-term gains, taxed at steep ordinary income rates.
Moreover, you will owe tax currently even if you reinvest the capital gain distribution as most investors do.
Trap: This unpleasant scenario can be especially hard to take when the stock market turns down. In a bad market, mutual fund investors often redeem shares, forcing managers to liquidate appreciated holdings to raise cash.
Example: Janus Fund lost nearly 15% in 2000, the year the tech-stock bubble burst. Yet investors had to pay tax on nearly $4 per share in capital gains distributions at a time when the fund's share price was around $35.
This experience was by no means unique. Many funds had larger losses and made larger distributions of taxable gains.
Bottom line: When you invest in a low-turnover, index-tracking ETF, you avoid this type of tax trouble.
Special Treatment
Certain mutual funds offer low turnover and tax efficiency, too. Indeed, there are many index mutual funds from which to choose.
Even when compared with index mutual funds, though, ETFs offer tax advantages.
Key: When they alter their portfolios due to a change in the underlying index, ETFs do not sell the securities they hold. Instead, they make "in-kind redemptions." These transactions involve large blocks of shares that are transferred among arbitragers, specialists, and market makers.
Loophole: Under the Internal Revenue Code, in-kind redemptions do not generate taxable gains to a fund. That's true even if the securities transferred by the fund have appreciated in value.
Another Benefit
Similarly, a rash of sales won't affect investors in an ETF as much as redemptions might hurt those in an index mutual fund.
Example: Vanguard REIT Index Fund (a real estate investment trust mutual fund) currently has unrealized capital gains equal to 30% of its value. If investor interest in real estate stocks suddenly plummets and there are massive shareholder redemptions, this fund would have to sell stocks, realizing taxable gains.
These gains would then be distributed to all remaining shareholders, even those who didn't sell shares.
The difference: If, instead of a mutual fund, you held an ETF that invests in REITs, such as streetTRACKS's Wilshire REIT Index Fund (AMEX:RWR), any shareholder selling would not cause capital gain distributions because there would be no change to the underlying stocks held in the portfolio.
Only the selling shareholders might incur capital gains. The continuing shareholders of this ETF would not owe taxes because of other shareholders' transactions.
Bottom line: Many ETFs have been on the market for years without ever having to make a taxable capital gains distribution to shareholders.
Cleaning Up
The tax advantages of ETFs go beyond the avoidance of unwanted capital gains distributions.
One popular strategy among savvy investors is "loss harvesting." When a stock or fund drops in value, a capital loss can be taken.
Advantage: Realized capital losses can offset capital gains, present or future, essentially making gains tax free.
Trap: Once a loss has been taken, the same security can't be repurchased during the next 30 days.
That's where an ETF can be used. An ETF can serve as a replacement for the security that you have sold, long or short term.
Example: You hold shares in a leading pharmaceutical company. A highly publicized study raises doubts about one of its drugs, sending the stock price down.
Now you have a large paper loss on that stock -- but you have not lost faith in the stock or the drug sector as a good holding.
Strategy: Sell the drug stock to realize a capital loss for tax purposes. You can't buy back the stock immediately, but you can buy an ETF such as Pharmaceutical HOLDRS (AMEX:PPH), which owns major drug companies.
Such a sale and purchase does not violate the wash-sale rules and won't jeopardize your tax loss.
Outcome: If you wish, after 30 days you can repurchase the drug stock you've sold. By then, the wash-sale rules don't apply.
If the stock has rebounded during your 30-day "time-out," you will pick up at least some of the gain through holding the ETF.
Related strategy: You can buy an ETF immediately after taking a loss on a similar mutual fund, without triggering a wash sale.
In addition, you can take a loss on one ETF and buy another right away, even if the replacement is in the same asset class.
Example: Let's say that large-cap stocks lose ground this year, so your holding of iShares S&P 500 Index (AMEX:IVV), a large-cap ETF, is underwater. You can take a tax loss and immediately purchase iShares Russell 1000 Index (AMEX:IWB).
Although these two ETFs are highly correlated, they track different indexes so they're not identical. Selling one and buying the other the same day won't annul your tax loss.
Key: Such tactics are practical because ETFs don't impose redemption fees on investors who buy and sell soon afterward. Such fees are increasingly common among mutual funds.
Caution: While ETF investors avoid redemption fees, they must pay transaction costs on each trade, just as they do when trading stocks. Therefore, you'll probably do best buying and selling ETFs through an ultra-low-cost discount broker.
The Right Account
To take advantage of the tax benefits, ETFs should be held in a taxable account. If you hold ETFs in a tax-deferred retirement account, you'll enjoy other ETF benefits, such as low expenses and easy tradability, but the tax advantages will be wasted. For more information about ETFs, go to www.etfconnect.com, sponsored by Nuveen Investments, and www.morningstar.com.
