ETF Tax Efficiency and Swapping Strategies
By J.D. Steinhilber, Contributing Writer

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 advisors and investors because delaying the taxation of appreciating assets normally enhances after-tax returns over time.

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 (1). 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.

Due to the efforts of fund managers to outperform their benchmarks, actively managed mutual funds almost invariably experience more "manager-driven" portfolio turnover than ETFs, where trading is generally only driven by changes 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.

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 manner 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 nontaxable, "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." Once created, the S&P 500 ETF can be subdivided into individual shares that are tradable by investors on the exchange.

As a result of this process, investors are insulated from a tax standpoint from 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.

In addition to their tax efficiency, ETFs lend themselves to certain tax minimization strategies.

Tax Strategies using ETFs

In addition to their tax-efficiency, discussed above, ETFs facilitate strategies to recognize losses for tax-planning purposes. Losses may be used to offset current or future capital gains and also may be used to offset a limited amount of ordinary income. ETF tax-planning strategies fall into two primary categories - "swaps" between ETFs and substitutions of ETFs for other securities.

An example of a swap strategy using ETFs is illustrated in the first figure below. In this scenario, the investor is simultaneously selling one small-cap ETF and purchasing another. This transaction should not be subject to "wash-sale" restrictions (which would disallow losses if substantially identical securities were purchased within 30 days of a sale), because the 2000 small-cap companies that constitute the Russell 2000 are not "substantially identical" to the 600 companies that constitute the S&P 600. In this example, in addition to recognizing a hypothetical loss on the Russell 2000, the investor is switching into arguably a superior small-cap index. Over the 10-year period from October 1992 to October 2002, the S&P SmallCap 600 generated an excess return of 4.0% per year versus the Russell 2000 (2).

An example of a substation strategy is illustrated in the figure below. In this scenario, the investor is simultaneously selling a large-cap mutual fund and purchasing a large-cap ETF. This transaction should not be subject to "wash-sale" restrictions either (assuming the large-cap mutual fund being sold is not an S&P 500 index fund). Other than the potential tax advantages of realizing a loss, an investor might undertake this strategy in order to exit a mutual fund that may be failing to outperforming the benchmark index and, in the process, is charging higher fees than ETFs, and making capital gains distributions.

11/20/2002

J.D. Steinhilber is the founder of AgileInvesting.com, an investment advisory web site that recommends ETF-based portfolios.

References

(1) "Fund Distributions are a Taxing Problem; How the Tax Man Dines on Your Funds." Jonathan Clements, The Wall Street Journal, August 1999.

(2) Morgan Stanley Research

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