Tax Efficiency

As we have seen, mutual funds have a potentially large disadvantage when it comes to taxable distributions. The investor has no control over what the fund will distribute in a particular year, and therefore can face a large tax bill on the distributions. The year 2000 is now famous, or infamous, for just such events. Many mutual fund managers took some gains early in the year following the great market years of the late 1990s, and then when the market declined and the funds had to sell shares to pay redeeming shareholders, still more taxable distributions were realized.

ETF investors are protected, but perhaps not as much as many assume. They definitely are protected from redemption gains. Mutual funds, including index funds, are vulnerable to investors leaving the fund in sufficient numbers that the fund manager must sell portfolio positions to buy back shares of departing investors. Because of the unique redemption feature of ETFs, they are able to avoid such transactions.

However, ETFs are not protected when sales of positions in the portfolio must be made as a result of changes in the associated index, or even by diversification issues. This is quite possible with a smaller fund where rebalancing needs can arise fairly often. Think of an ETF invested in shares of a small foreign country, and holding perhaps 30 or 40 stocks. Should one of these stocks appreciate substantially, the manager might feel compelled to reduce the size of the holdings of this strongly performing stock, thereby generating a taxable distribution.

Regardless of the cases just mentioned, many of the well-known ETFs are very tax efficient. Let's compare Vanguard's 500 Index Trust (one of the two largest mutual funds in the United States) with the S&P 500 Spider. Both are based on the S&P 500 Index, an extremely popular and well-known measure of the stock market.

For the years 1997 through 2001, the capital gains distributions for the Vanguard 500 Index Trust were $2.01, compared with nothing for the S&P 500 Spider. Clearly, ETFs can be tax efficient when it comes to capital gains distributions.



Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
ISBN: N/A
EAN: N/A
Year: 2004
Pages: 94

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