The Tax Issue

For those investors with substantial potential tax liabilities, it is important to consider doing something else now. This is a significant issue that has gained increasing attention.

Traditionally, mutual funds have not paid much attention to the tax implications of their transactions. They buy and sell as they think best, and let the chips fall where they may. They certainly fell in 2000, when investors got those large distributions just as the prices of their mutual fund shares were declining sharply. That was a truly costly lesson that should not be forgotten soon.

With mutual funds, a buyer might be purchasing embedded taxes because the fund has large gains that have been earned, and will be realized and distributed after he or she becomes a shareholder. In effect, purchasers of mutual funds are sometimes literally buying a future tax liability. Consider also the situation in which the fund must sell securities to meet redemption requests , but would not sell these securities otherwise at this time. The shareholders then face unwanted capital gains taxes.

Let's consider the case of a U.S. investor in a high tax bracket . This investor has other income that is taxable, and wishes to minimize capital gains taxes on distributions. This investor could buy an index fund or an ETF. Clearly, actively managed mutual funds can potentially generate large capital gains distributions, resulting in hefty tax bills. And they do!

An index fund must sell shares from time to time to meet shareholder redemption requests. It also sells shares when the structure of the index changes ”for example, a company drops out of the index, or a new company is added ”which requires cash from somewhere. As index funds age, they may accumulate capital gains that ultimately get passed on to shareholders.

An ETF, in contrast, with its redemption-in-kind feature, can avoid most capital gains taxes for shareholders of the account. However, like the index fund, as the ETF ages it can accumulate built-in gains.

Consider the Vanguard 500 Index Fund, the largest mutual fund in the United States, and the Spider, an ETF dating back to 1993. Over the five-year period between 1996 and 2000, there were capital gains distributions for each of these five years for the index fund, but they were small. As a percentage of NAV, the distributions ranged from 0 percent up to approximately 0.75 percent. The sum of the five years was slightly in excess of 2 percent.

Insights

Does the difference between ETFs and tax-efficient index funds matter when it comes to capital gains distributions? The differences have not been large in some cases, but there are differences. The differences, when it comes to receiving taxable distributions, are typically in favor of the ETFs.

Spiders, in contrast, made a distribution in only one of the five years, 1996. This was a small distribution, about 0.16 percent of NAV.

With folio investing, investors can take control of the tax situation in terms of timing. They can decide to sell an individual stock based on their particular tax situation. Also, an investor can realize a tax loss by selling a stock with a loss, which can make sense in certain situations.

It is in the area of tax efficiency that managed accounts can offer a real advantage over mutual funds. With a separate account, the cost basis is determined at the time the security is purchased. The client has control over the sale of the securities, which should result in better tax planning. Taxes are not due until securities are sold, so control the sale date and you control when the tax is due. As the client, you can ask the manager to take some losses to offset some gains you have elsewhere. You can ask for a customized trade that fits your tax situation very closely.

In summary, a number of investors can go their entire investing lifetime using mutual funds and do quite well. By using index funds, low-cost actively managed funds, tax-efficient funds, and so forth, and by being aware of the issues involved with mutual funds, these investors can do as well as, or better than, most other investors. Nevertheless, the alternatives now available can offer some distinct advantages to particular investors, and they should take advantage of them. Individual investors have situations that vary from person to person, and the flexibility offered by the alternatives can be quite valuable .