While mainstream and casual investors alike remain largely oblivious to the negative impact taxes can inflict on the performance of an investment portfolio, savvy advisors know never to underestimate this factor. In fact, the emergence of exchange-traded funds has converted an entire generation of financial advisors to the (correct) belief that tax efficiency is an important component of portfolio management. ETF sponsors have been instrumental in educating advisors to the tax advantages of ETFs versus conventional actively managed mutual funds.
To illustrate, here’s a few stunning statistics taken from Lipper’s 2005 survey of taxes in the mutual fund industry:
o The 2005 estimated taxes paid by shareholders in taxable mutual funds increased 58 percent from 2004. In real money terms, that figure translates into $15.2 billion lost to taxes.
o Taxable investors in open-end mutual funds surrendered an average of 1.6 to 2.4 percentage points of performance a year over the 10 years ending Dec. 31, 2005 to taxes.
o Taxable equity and fixed-income funds gave up about 20 percent and 45 percent of their respective load-adjusted returns to taxes.
o In most instances, taxes on taxable fixed-income funds created a performance drag for the five-year period ending Dec. 31, 2005 of two to three times that of the funds’ associated expenses.
After considering the numbers, is it any wonder why the investing masses consistently underperform key stock market indexes? Whether they realize it or not, taxes are killing them.
With a little planning, financial advisors can be ready to successfully tackle the tax issues of portfolio management. While having a CPA isn’t a requirement, awareness of strategies that minimize the impact of taxes is essential. The end of 2006 is rapidly approaching, so there’s no better time than now to revisit a few ideas that can make taxes less taxing.
1. Use the right financial products. The first step to minimizing the negative impact of taxes is to use tax-efficient investment vehicles. To that end, ETFs are famous for their low portfolio turnover and high overall tax efficiency. In fact, the entire menu of ETFs offered by Barclays Global Investors under the iShares umbrella reported zero capital gains distributions in 2005. Commenting on this feat, Lee Kranefuss, CEO of BGI’s intermediary and ETF business, explains that “Few fund families can offer over 100 funds covering nearly every asset class, style and sector, along with tax efficiency due to the fund’s low portfolio turnover and unique ETF structure.”
While specific tax distributions vary with each fund company, a generally good track record of tax efficiency is evident throughout the entire ETF industry.
2. Understand that some ETFs are taxed differently. In taxable accounts, ETF returns are taxed as long-term gains if the fund was held for more than one year (at least a year and a day) before it was sold. If your tax bracket for ordinary income is 10 or 15 percent, the rate on this category of capital gain is equal to 5 percent, whereas capital gains are capped at 15 percent for ordinary tax brackets that are 25 percent or higher.