ETFs for Tax Planning

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Exchange-traded funds are often regarded as more tax-efficient than traditional mutual funds largely due to the fact that many ETFs have been able to avoid the annual capital gains distributions that often frustrate investors in traditional mutual funds.  As we progress toward the end of another tax year, many investment advisors are also finding ETFs to be effective tools for tax planning purposes.

ETFs’ Tax Efficient Structure

The relative tax efficiency of many ETFs is principally a result of the process by which ETF shares are created and redeemed.  For most “plain vanilla” equity ETFs, the creation/redemption of shares is facilitated by large institutional investors via an in-kind exchange of an ETF’s underlying holdings for large blocks of ETF shares known as “creation units”. This process generally enables these ETFs to grow and contract without forcing a fund’s portfolio manager to buy or sell securities, potentially realizing capital gains and triggering taxable distributions to investors.

However, not all exchange-traded products share in the tax efficiency associated with plain vanilla equity ETFs.  For example, levered and inverse ETFs are often less tax efficient because these funds generally utilize a high level of portfolio turnover to achieve their objectives, increasing and decreasing exposure to various asset classes on a daily basis via derivatives, such as swaps and futures contracts.  As a result, many levered and inverse ETFs have historically made substantial capital gains distributions to investors.

Additionally, there are a few odd cases in which ETFs may produce less tax efficient exposure than their underlying holdings.  Such is the case for ETFs that track master-limited partnership indexes.  As discussed in August’s ETF Advisor column, when an ETF allocates more than 25% of its portfolio to MLPs, it no longer qualifies as a tax-exempt, regulated investment company; instead, these funds are subject to federal corporate income tax.  This tax liability is reflected in the daily calculation of a fund’s net asset value, which has often resulted in significant tracking error between MLP ETFs and the indexes that they follow.

ETFs for tax planning purposes

While the tax efficiency of individual ETFs may differ, based largely on the asset classes in which the funds invest, ETFs in general have become popular tools for managing the tax liability of investment portfolios held in taxable accounts.

One popular tax planning strategy that utilizes ETFs is implemented by selling certain positions within an investment portfolio at a loss so as to offset realized gains elsewhere in the portfolio, thereby minimizing tax liability in the current year.  In order to avoid the possible performance drag created by an unwanted cash position, and to maintain the portfolio’s overall investment objectives, proceeds from this sale may then be invested in a highly correlated ETF with similar attributes.  This ETF position may then be maintained in the portfolio, or it may be sold and replaced by the original position after 30 days in order to comply with the wash sale rule.

Another tax-planning strategy, for which ETFs have become poplar tools, seeks to mitigate the current tax impact associated with diversifying highly-appreciated individual stock positions within an investment portfolio.  For this strategy, investors systematically harvest losses from the holdings of an ETF asset allocation portfolio, which are used to offset gains realized from the sale of shares in a highly-appreciated stock.  Once again, in order to maintain the portfolio’s investment objectives, the proceeds from the sale of the ETF may then be invested in another highly-correlated ETF.  Meanwhile, the proceeds from the individual stock sale may be allocated within the guidelines followed by the overall investment portfolio.

Tax planning strategies have been utilized by investors for many years, and numerous versions of the strategies mentioned above have been implemented via traditional mutual funds before the advent of exchange-traded funds.  Today, however, many investment advisors have found ETFs to be more effective and precise tools than traditional mutual funds in the pursuit of these types of strategies.  Not only do ETFs generally offer greater portfolio transparency, which aids in the process of selecting an appropriate ETF to replace a recently sold position, but ETFs also offer enhanced liquidity versus traditional mutual funds, allowing for intraday trading, as well as avoiding the restrictions on frequent trading that are sometimes implemented by traditional mutual funds.

While the fourth quarter is often the time that investors focus on tax-management strategies, mitigating tax liability should be a year-round pursuit.  In the hands of skilled investment professionals, ETFs are useful tools for implementing many of these strategies.  Those advisors that take this challenge seriously provide added value to the investment process, and maintain a competitive advantage over those who fail to do so.

As always, we urge you to consult your tax advisor for specific information about tax loss harvesting and the wash sale rule.

This summary is not intended to be tax or legal advice.  This summary cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.  This summary is being used to support the promotion of the transactions herein.  The taxpayer should consult an independent tax advisor.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs , Mutual Funds , Taxes

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Ryan Issakainen

Ryan Issakainen

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