ETFs and Tax Efficiency

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A Better Financial Product than Mutual Funds?

[By JD Steinhilber]

Exchange-traded funds are inherently more tax efficient than actively managed mutual funds, which have been rightly criticized for their tax-inefficiency. Tax-efficiency is a critical issue for financial advisors and physician-investors because delaying the taxation of appreciating assets normally enhances after-tax returns over time.

For example, it is estimated that between 1994 and 1999, investors in diversified U.S. stock mutual funds lost, on average, 15% of their annual gains to taxes. The tax inefficiency of mutual funds is the result of portfolio turnover at the fund level caused by two factors: the trading activity of the portfolio manager and the activity of other shareholders in the fund.       

The Mutual Fund Performance / Redemption Problem

Due to fund manager efforts to outperform benchmarks, actively managed mutual funds almost invariably experience more “manager-driven” portfolio turnover than ETFs, where trading is generally driven by change in the composition of the underlying indexes being replicated. Mutual fund portfolio turnover can also be caused by the actions of shareholders in the fund. 

In a mutual fund structure, redemption requests by shareholders can force the fund to sell securities to raise cash. These sales may give rise to gains that, by law, must be distributed and will be taxed to all shareholders in the fund.

Unique Architectural Structure

ETFs, in contrast, are structured in such a way that the actions of one shareholder do not result in tax consequences to another shareholder.  ETFs accomplish this through the innovative architecture in which ETF “units” (which are subdivided into individual ETF shares) are created and redeemed to accommodate the fluctuating demand for the shares of a particular ETF.

ETF units are created and redeemed by institutional investors though non-taxable, “in-kind” transactions, which means that only securities – not cash – change hands in the creation and redemption process. 

An example of this process would be an institution exchanging a portfolio of stocks constituting the S&P 500 index for an S&P 500 ETF “creation unit”. And, once created, the S&P 500 ETF can be subdivided into individual shares that are tradable by investors on the exchange.   

Assessment

As a result of the above – physicians may be insulated from a tax standpoint by the actions of other investors – because taxable transactions don’t take place at the fund level.  Instead, ETF shares are traded between retail investors in transactions on the exchanges, so the tax accounting becomes very similar to that associated with individual stocks.    

Have you used ETFs in your own portfolio, and what is your tax efficiency experience with them; truth or hype? 

Conclusion

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5 Responses

  1. ETFs are “Hot”

    JD – I could not agree with you more. Forget about mutual funds.

    And, did you know that ETF investors are wealthier, younger and better-educated than others, according to research findings compiled by Cerulli Associates, Inc and the Investment Company Institute (ICI)? Just like readers of this ME-P; perhaps.

    With the market collapsing, now might be the time to start considering them on the cheap.

    Dr. David Edward Marcinko MBA CMP™
    http://www.CertifiedMedicalPlanner.com

    Like

  2. Record-keeper Calls for Retirement Plan Revolution with 401(k) ‘Manifesto’

    Invest n Retire, a record-keeper based in Portland, Ore., that specializes in offering ETFs to defined-contribution plans, recently released a white paper calling for a “revolution in the retirement industry, the core of which is an entirely new structure designed around exclusively offering exchange-traded funds as investment options.”

    http://www.advisorone.com/2011/12/15/recordkeeper-calls-for-retirement-plan-revolution?ref=hp

    The record-keeper calls ETFs the ‘only truly viable’ way to enact change that will lead to higher account balances.

    Regan

    Like

  3. No-fee ETFs – Is there a catch?

    Online brokers increasingly offer fee- and commission-free funds to their customers.

    http://money.msn.com/exchange-traded-fund/no-fee-etfs-is-there-a-catch

    But, are there hidden drawbacks?

    West

    Like

  4. ETFS

    Exchange-traded funds provide the diversification of index funds with the convenience of stock exchanges. With one investment, you can track assets that include stocks, bonds and commodities. ETFs have lower risk and require far less work than picking specific stocks. They also automatically rebalance over time as the economy changes, and they’re tax-efficient.

    Clyde

    Like

  5. Are ETFs a homogeneous bunch?
    [NO … WAY]

    I’m always a little amused when I hear broad statements about ETFs as if they’re a uniform group of investments. In reality, there are more than 1,500 ETFs trading in the United States, with many different investment strategies and structures.

    When I look at the list of the largest ETFs, I see a wide variety. There are broad U.S. stock funds tracking indexes such as the S&P 500 right next to emerging-markets equity funds holding securities from over 20 countries such as China, Brazil, and South Africa.

    There are large total-market bond funds that invest in thousands of investment-grade bonds across all sectors and maturities and other funds investing exclusively in real estate investment trusts. There’s also an ETF holding a single asset: gold bars held in a vault in London.

    So, as you can see from just a sampling of very popular products, ETFs can be as eclectic as Elvis’s ’70s era jumpsuits!

    Blythe

    Like

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