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Tax-Hike Threats Put ETF Investors On Edge

The world of investments is abuzz about what the possibility of higher taxes might mean for investors next year and beyond, but at the end of the day, the uncertainty that the market abhors is perhaps the biggest concern as advisors nervously wait to see what politicians in Washington, D.C., end up doing.

Yes, some investors are taking money off the table in preparation for the possibility of both a higher long-term capital gains rate and even an increase in the amount dividends are taxed. Indeed, through all the possible permutations of what looks like the most ambitious re-tooling of U.S. tax code since 1986, the fate of capital gains and dividend taxes loom most largely, analysts agree.

Still, plenty of others aren't doing anything at all because they either don't want to second-guess lawmakers, or because they see taxes as less important than simply staying the course.

But as ConvergEx Group's market strategist Nicholas Colas said, recent outflows from equities mutual funds accompanied by inflows into equities ETFs tell the tale of investors choosing to take a tax hit now in expectation that the long-term cap-gain rate will almost surely jump higher than the current level of 15 percent. But, just as quickly, they're keen on rolling back into similar, but cheaper, positions using ETFs.

"People are getting out of mutual funds they've been in for years, but they want to keep their allocation the same, so they are switching into ETFs," Colas told IndexUniverse recently. "We know tax rates are unsustainable, so we are going to see mutual fund outflows and ETF inflows accelerate between now and the end of the year," Colas said, arguing that is likely to fuel an acceleration of ETF inflows.

'You've Got To Do The Math'

Putting off any decision about taking capital gains is especially true for those with longer holding periods and for whom the calculation is a bit more complex.

"Anyone who will have to realize capital gains in the next three or so years, should take them now," Larry Swedroe, the Research director at BAM Alliance-the entity that encompasses all $18 billion in assets directly or indirectly linked to Buckingham Asset Management-told IndexUniverse in an interview this week.

"But, you've got to do the math," he added. "If it's 20 years, you probably don't want to do it, because then you get that continued deferral, and who knows what the tax rate will be in 20 years when you take the money out?"

"On the other hand if it's four five years, you do the math and you make a decision," Swedroe said, stressing that given all the variables in play, now is truly a time for investors to consult a tax professional to help them make all the right calls.

Taking Measure Of The Possibilities

IndexUniverse Analyst Carolyn Hill earlier this year outlined just how much higher taxes on things like dividends, interest, and short- and long-term capital gains could be if Obamacare does indeed get rubber-stamped, which looks like a pretty sure deal given that the president was re-elected.

Taxes would be going up by 3.8 percentage points on all joint filers with adjusted gross income of more than $250,000, and on single filers with incomes over $200,000-changes that would take effect a full year before the health law is scheduled to kick in, Hill said in a blog last summer.

"This additional tax could potentially have a significant impact on all the dividend-focused ETFs that have been so popular lately," Hill said. "A 3.8 percentage point tax hike may not seem like a big deal until you consider it in the context of tax rates as they currently stand-and what they could rise to if the Bush-era tax cuts aren't extended."

Indeed, dividends are currently taxed at 15 percent, but could be taxed at 18.8 percent next year, and if Bush-era tax cuts aren't extended, those rates could soar to 43.4 percent. Taxes on long-term capital gains would meanwhile rise to 23.8 percent, Hill said.

Mass Exodus From Dividend Securities?

Does all this mean that the heavy inflows into dividend-focused stocks and ETFs will soon reverse? That depends on who you ask.

"The upcoming hike in capital gains taxes is a huge negative for dividend equities in the U.S.," Mebane Faber, Cambria Investment Management's chief investment officer, told IndexUniverse. "When dividends are taxed at a disadvantaged rate relative to capital gains, fewer companies pay out dividends, and they pay out less in dividends over time."

In fact, he said, the number of S&P companies that pay dividends used to be near 100 percent, but now that's down to around 70 percent.

"Funds that don't target a more holistic measure of cash flows-meaning dividends; plus buybacks; plus debt pay-down-and focus on dividends alone, are going to underperform quite a bit in the coming months and years," he said.

"All of this money that has been rushed into dividends in the past few years is going to have a rude awakening when they start to underperform," Faber said.

Still, not everyone is betting on a mass exodus from dividend-paying stocks or even dividend-focused strategies.

"I don't think people are going to be completely running from existing positions in existing dividend portfolios," S&P Capital IQ's Todd Rosenbluth told IndexUniverse recently.

That's because those who invest in such stocks and funds typically do so for dependable income-all the more so given how low yields on many fixed-income investments have dropped since the market crashed in 2008, Rosenbluth said.

"I don't think we'll see the same interest in dividend ETFs, but I don't think we're going to see a mass exodus out of these portfolios," Rosenbluth said.

But for investors who are concerned with what's going to happen and want steady--even improving-income, looking at ETFs that hold stocks of companies that have continued to increase payouts are "good places to look, Rosenbluth said."

Funds like the $9.2 billion SPDR S&P Dividend ETF (NYSEArca:SDY), which have a mandate to own securities with increasing dividends, fit the bill perfectly, he said.

Munis Could Shine Even More Brightly

If the outlook for dividend stocks and ETFs is somewhat murky, the same can't be said about federal-tax-exempt municipal bonds.

"Munis will benefit from a rise in personal income taxes," Van Eck's Jim Colby told IndexUniverse. "Even in the worst case scenario, where nothing is done to prevent the fiscal cliff, munis would still benefit greatly."

So far this year, the muni market saw positive inflows in nearly every week save for two-the one before the election and the week of the election, respectively-Colby said, noting uncertainty surrounding the election and also Hurricane Sandy's impact on the East Coast was behind those slowdowns in demand.

"But once the election was past, we've seen a resumption of inflows to the tune of $1 billion a week into the muni market," Colby said. "The evidence is substantial that the investing public has great confidence in munis."

Year-to-date, munis have been top performers in the fixed income space, returning some 6.4 percent, as measured by the Barclays Muni Bonds Index. High-yielding munis have seen returns twice that amount.

"At the beginning of the year, I had thought that if we ended the years ahead just by the value of the average coupon-5 percent-we could consider this a very good year for munis," Colby said. "We are poised to do much better than that."

Any tax adjustments made to prevent a fiscal cliff should be supportive of munis-unless munis lose their federal tax exemption in any revamp of the tax code, he said.

"While the idea of eliminating the exemption hasn't gained a foothold, it hasn't gone away either," Colby said. "But that's a dangerous proposition to pull the country out of a stagnant economy. It's not an efficient way to move forward."

That possibility, though remote, is just one more example of all the uncertainty that's infused into the various and sundry possibilities connected to the prospect of higher taxes.

Don't Forget To Stay The Course

All the uncertainty is anxiety provoking to be sure, but it shouldn't drive the storyline for investors who make or break their fortunes by having staying power, whatever the tax regimen.

"Like it or not, I think we are all going to pay more taxes," Eric Pollackov, a managing director of ETFs at Charles Schwab, told IndexUniverse recently on the sidelines of the Schwab Impact conference in Chicago. "But I don't think you should make an investment or sell an investment based on tax implications alone," Pollackov said.

"I do think it's something you should be thinking about, but it shouldn't be the tail that wags the dog."

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Copyright ® 2012 IndexUniverse LLC . All Rights Reserved.

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

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

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