Maybe not. ETFs can help you avoid the taxman, but keep an eye on out for special situations.
Capital gains distributions. Dividend taxes. 1099s.
The very words send a shiver down the spine of
prudent investors. Or at least they should: According to John Bogle of
Vanguard, the average investor in an actively managed mutual fund
forfeits 2.2% each year to taxes. Index funds do better, taxing the
average investor just 0.9% per year. But still, it adds up.
A First Quadrant study published in 2000 found that
$1,000 invested in the Vanguard 500 Index Fund in 1980 would have grown
to $24,000 on a "pretax" basis over 20 years. Take out taxes on capital
gains distributions and dividends, however, and that number shrinks to
$16,200.
For active fund investors, the story gets worse.
According to the First Quadrant study, the same $1,000 invested in the
average actively managed fund in 1980 grew to just $19,600 pretax over
20 years. After you account for taxes on capital gains distributions
and dividends, the net return dips to $11,300. In other words, taxes
ate up $8,300 in returns on a $1,000 investment.
What's amazing is that these numbers only include
distributions and dividend taxes from the fund itself-you know, the
little numbers on those innocuous 1099 forms. The capital gains that
investors pay when they ultimately sell their funds are extra.
You may not have heard much griping about taxes
lately, because distributions have been at record lows. In the
aftermath of the Internet bubble, many funds were able to harvest
losses and shield investors from capital gains. As a result, mutual
fund distributions fell from a record 6% of assets in 2000 to less than
0.3% of assets in 2003. But that number is creeping up: Funds paid out
$155 billion in capital gains in 2005, according to the Investment
Company Institute, up from just $55 billion in 2004. And that number
will rise again in 2006.
Moreover, with dividend payouts increasing,
investors are beginning to learn the hard way that Uncle Sam doesn't
treat all dividend income the same, and that the dividend tax bite can
hurt, too. In other words, taxes are starting to matter again.
Enter ETFs
What's an advisor to do? Well for starters, you should take a close look at exchange-traded funds (ETFs).
ETF designers have been crowing about the tax
efficiency of their funds since the first ETF launched in 1993.
Traditional mutual fund companies have disputed that claim vigorously,
but the data is increasingly on the side of ETFs. A recent study by
Morningstar found that "the vast majority of domestic and international
ETFs with five-year records ranked in the lowest half of their
respective categories and broad-asset classes [for tax-cost ratio]."
Most ETFs have never paid a capital gains distribution, and although
traditional index funds have been very tax efficient recently, over the
long haul, ETFs have the edge.
Here's why: When individual investors sell shares in
an ETF, they don't redeem them directly from the fund. Instead, they
simply sell them on the open market. The sale has no impact on the
holdings of the fund, so there is no possibility for capital gains. In
contrast, when a mutual fund shareholder redeems shares, the fund must
sell stock to raise cash and pay that investor.
ETFs still can create capital gains when the index
they track is rebalanced, or when a component is acquired. But even
here, ETFs have an advantage. That's because Authorized
Participants-the big boys who help create liquidity in ETFs-create and
redeem ETF shares directly from the fund manager, in what's called an
"in-kind transaction." If they hold 50,000 shares of an ETF, for
instance, they can return those shares to the ETF manager and receive
shares of the underlying stocks in return.
When this happens-and it happens a lot-the ETF
manager gets to choose which shares to deliver. The folks who run these
things are not dummies, so they deliver shares with the lowest cost
basis. It doesn't matter to the Authorized Participant-they pay taxes
on their own cost basis-but for the fund, it's a huge win. Over time,
they can slowly but surely get rid of any "capital gains overhang." As
a result, when the fund is forced to sell shares during a rebalancing
or as the result of a takeover, they have all high-cost lots to choose
from.
Traditional mutual funds don't have that option: The
Vanguard 500 Index Fund, for instance, is sitting on unrealized capital
gains equal to 27% of the fund's value as of year-end 2004. By
comparison, the world's largest ETF, the SPDR (SPY), which tracks the
same index, had an unrealized capital loss equal to 20.7% of the fund's
value, according to an article, "The Anatomy of Tax Efficiency," by
Gary Gastineau in the May/June 2005 issue of the Journal of Indexes.
Vanguard is a superb manager of capital gains, and has so far managed
to avoid paying out capital gains. But if the current bull market
continues, the arithmetic will get tough.
"Obviously, we like redemptions, because we're
pushing out the stock with a lower cost basis in our portfolio," says
Tim Meyer, business line manager for ETFs at Rydex Funds. "That helps
the overall tax efficiency of the ETF."
How well does this work? Very well. Barclays Global
Investors (BGI), which manages the lion's share of U.S. ETF assets, has
delivered zero capital gains on any of its funds-that's 101 funds with
$160 billion-plus in assets-for the past five years. And BGI isn't the
only one: Rydex (nine ETFs), PowerShares (36 ETFs) and Vanguard (23
ETFs) all paid out zero capital gains in 2005; State Street Global
Advisors, the second-largest ETF manager, posted small distributions
for just 3 of its 31 funds last year.
BGI's Berg says that sustaining zero capital gains
over the long haul might prove impossible, especially in sectors that
experience huge run-ups followed by severe pullbacks. If oil or housing
stocks tumble in the next few months, for instance, watch out.
It also pays to watch out for the newer ETFs.
According to Meyer, "[I]t's more difficult for newer ETFs to manage
capital gains, because they don't have enough redemption activity to
pass on the highest-cost shares outside the fund."
Meyer says that Rydex was almost forced to pay a
distribution on its Rydex Equal-Weight Fund (RSP) in 2003, its first
year on the market. The fund actually sold some losing components
specifically to offset gains on its books, risking a small tracking
error to avoid the distribution. "We only actively manage for capital
gains," says Meyer. "We do not actively manage to outperform."
The case of RSP points out just how effective the
ETF methodology is in preventing capital gains. RSP holds all 500
stocks in the S&P 500 index, but it holds them at equal weights. To
maintain that weighting, the fund is rebalanced every three months,
selling the 250 stocks that have performed well and buying the 250
stocks that have performed perfectly. It's the perfect recipe for
capital gains, especially with turnover that reached 55% last year. But
despite three consecutive years of solid returns (22%), the fund has
never made a capital gains distribution. That may not be sustainable
for the long haul, but it is impressive.
Don't Forget About Dividends ... And There Are Differences
Here comes the "Yes, but..."
Capital gains get all the press, but the truth is,
they are only one-half of the story. The dividends you receive from
funds also get taxed, and here, ETFs don't always fair so well.
The 2003 dividend tax cut lowered the tax rate on
dividend payments from a maximum of 35% to just 15%. But in order to
qualify for this tax rate, dividends must be "qualified": You (or your
fund) must hold the stock paying the dividend for 61 days, most foreign
dividends are excluded and REIT income is excluded. There are other
ways that funds can run afoul of the "qualified dividend" (or "QDI")
rules, such as by loaning out shares for securities lending. But these
are the basics.
ETFs experience a lot of "velocity," with asset
counts rising and falling by huge numbers on a weekly basis. With all
this movement, the funds sometimes run afoul of the 61-day holding
period.
"It's still a relatively new feature of the tax
code, and it's one that people aren't accustomed to," says Paul Lohrey,
principal with Vanguard's Quantitative Equity Group. "Most investors
are accustomed to looking at capital gains distributions as the
determinant of tax efficiency, but unfortunately, it's a little bit
more complicated than that."
The issue raised some eyebrows in 2004 when the
iShares Dow Jones Select Dividend ETF (DVY), a fund created to
capitalize on the 2003 dividend tax cut, paid out 28 cents of
nonqualified income as part of a $1.91/share dividend payout. That
shaved about ten basis points off of the after-tax return.
In 2005, fund managers seemed to be more aware of
the dividend issue, and they managed the problem much better. DVY, for
instance, posted 100% QDI for the year, as did many other ETFs.
But some funds weren't so lucky. The iShares Russell
2000 Index Fund (IWM), for instance, paid out half of its distributions
as nonqualified income, largely because the Russell 2000 Index includes
REITs. Foreign funds struggled as well, with funds like the iShares
S&P Europe 350 Index Fund (IEV) paying out 41% of its dividends as
nonqualified gains.
The net impact of these distributions is small-a
tenth of a percent here, 15 basis points there. But it adds up. And
with dividend payouts rising-they're up 36.5% from 2003-2005-it is an
issue to consider.
It's too early to say whether ETFs are truly
disadvantaged here. But because mutual funds tend to have more
long-term investors with longer track records, they are more likely to
meet the 61-day standard.
"If you look at a fund with conventional share
classes, mutual fund complexes encourage holders to be long-term
investors," says Lohrey. "We police against [short-term trading], as do
other fund complexes. There tends to be less velocity ... and so a higher
proportion of the dividends will meet the QDI test."
Deserving special attention is the issue of REIT
income, because it's not clear that investors understand it has
negative tax implications.
Consider this: As of May 3, the iShares Dow Jones
U.S. Real Estate Index Fund ETF had an effective yield of 3.68%. Since
this income is non-QDI, for a high-net-worth investor the after-tax
yield is 2.39%. By comparison, the iShares dividend ETF mentioned
earlier yields 3.57%, or 11 basis points less than the REIT fund. But
last year, 100% of that payout was QDI. If that stays the same in 2006,
the effective after-tax yield is 3.12%, or 49% higher than the REIT.
One other special situation is silver and gold
bullion ETFs. More than $7 billion is tied to the gold ETFs, and the
iShares-sponsored silver ETF attracted nearly half-a-billion dollars in
its first week of trading. Investors may not realize, however, that
these funds are tax disadvantaged. According to the IRS, gold and
silver bullion are "collectibles," not "investments," and as such are
subject to a 35% capital gains tax.
Although gold and silver mining companies are not
perfectly correlated with the price of bullion and come with the risks
of corporate mishaps, the tax situation makes them worth considering. A
gold mining ETF is in the works.
Taxes are the naked emperor that the mutual fund
industry does not like to mention. Of course, investors need to look
beyond taxes. They also should consider transaction costs (critical for
ETFs), loads, expense ratios and internal portfolio turnover.
Moreover, there continues to be substantial debate
about how tax efficient ETFs truly are, and dividends do pose a threat.
A recent study by Lipper Associates pointed to ETFs' relative
inefficiency with dividend income to argue that traditional index funds
might be better. Maybe. But with a bull market entering its fifth year
and more funds facing cap gains overhang, it's a risk I might be
willing to take.
Matthew Hougan is assistant editor of Journal of Indexes.