Tax Advantages

Posted 06/19/2009, 12:00 am EST by Will McClatchy from ETFzone.com

ETFs are quite tax-efficient. Because of the way they are created and redeemed, they allow an investor to delay paying nearly all capital gains until final sale of the ETF. Delay is valuable because the tax money continues to compound returns in the investor's account until the ETFs are sold.

Traditional mutual funds, and especially actively managed mutual funds, force investors to pay capital gains taxes nearly every year. There are two main triggers. One trigger is during the regular turnover of stocks as the fund manager buys and sells stocks to try to outperform the market. This generates a slow, steady drip of capital gains. The second trigger is when large numbers of investors cash out (typically in a bear market), and the fund is forced to shrink its portfolio. This generates an occasional but sometimes severe capital gains distribution. It is galling to receive a tax bill simply because other investors decide to leave, but that is what happens.

ETFs rarely encounter these two scenarios. How do they do it? ETFs are created by trading equivalent certificates (the ETF for a basket of stocks) in what is called an in-kind trade. This exchange of essentially identical items does not trigger capital gains, according to the IRS, the way a cash-for-stock exchange would. Traditional mutual funds must go into the open market and exchange cash for stocks and vice versa. A subtle twist is that during the in-kind exchange, the ETF can constantly shed its older, lower-basis stocks, keeping its higher-basis stocks (for which potential capital gains are small). These tax loopholes result in a decided advantage for the ETF investor.

Exactly how much an investor benefits depends on their marginal tax rate, the return of the investment, and how long they hold the investment. Overall, ETFs are similar to a handful of tax managed index mutual funds, slightly more efficient than standard index mutual funds, and significantly more efficient than the vast majority of active mutual funds with high turnover.

Occasionally an ETF fund that is only a few years old may throw off unusually high distributions in a market downturn.

It should also be noted that various classes of ETFs generate relatively high taxes. One is Exchange-Traded Notes (ETNs), which do not hold stocks but rather promissary notes backed by the provider. Another class is commodity-based ETFs which typically invest in futures contracts. Unlike stocks which underpin most ETFs and which generate mostly low long-term capital gains taxes, notes and futures generate more high short-term capital gains and ordinary income taxes.

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.