Serve up returns, but hold the tax: ETFs are not only tax efficient, they can be used to execute a tax swap - Exchange Traded Funds

'Tis the season to grumble about taxes. And certainly no one likes to pay more taxes than they have to. Unfortunately, investing in equity mutual funds can have unpleasant tax consequences. This is because capital gains may be kicked out when a manager sells securities. Ironically, the job of an active manager is just that -- to buy and sell securities to try and beat the market. According to one study, the average active Canadian equity manager "turns over" 80% of their portfolio in a year. To compensate for the average tax liability on such a mutual fund, a manager must beat the index by at least 2% each and every year. And this must be done after fees. Few managers can make up for their fees and your tax liabilities in consistent stellar performance.

ETFs, on the other hand are tax friendly. This may sound like an oxymoron, but consider this: Since ETFs only change their composition when the benchmark index adds or drops a security, portfolio turnover is usually very low. For example, on average the S&P/TSE 60 Index turns over 8% of its holdings a year. Realized capital gains are kept to a minimum. This, combined with the much lower MERs on ETFs, means you get to keep more of your money working for you.

There's another good tax feature of ETFs. A run of redemptions on a mutual fund may force the manager to sell profitable positions in order to raise cash to pay out these redemptions. This could impose a capital gains tax liability on the remaining investors -- even though they're sitting tight. In contrast, retail investors sell their ETFs on the exchange for cash, which has no direct impact on the underlying fund whatsoever.

When ETFs do experience fund level redemptions, usually by institutions, they occur "in kind." ETF units are exchanged for the underlying securities in that ETF. Unfortunately, this is a taxable event in Canada, but in the U.S. it does not trigger a capital gains liability. Thus U.S. ETFs have historically had minute capital gains distributions. For example from 1993-to-2001 the "Spiders" (AMEX: SPY) appreciated from U.S.$45 to over U.S.$150 a share, yet distributed total capital gains of only U.S.$0.09 a share! Now that's what I call holding the tax!

Tax swaps using ETFs

A tax swap is selling one security for tax purposes and immediately buying a similar investment. This is often done to crystallize a capital loss to offset a capital gain. Swaps allow investors to maintain or alter their market exposure and asset allocation when they take a loss. Here's an example: Suppose you own a mutual fund in a specific sector, let's say Information Technology (IT), that has fallen in price. You think the sector has bottomed out, and have a favourable outlook for the long-term prospects for that sector. Sell the IT mutual fund and buy an IT Index ETF. You get the tax loss on the mutual fund but still have IT exposure. Swaps between mutual funds and ETFs work very well, as do swaps from ETF to ETF.

The same strategy can also be employed if you own one or more stocks in a sector that has fallen, but you have faith in the sector for the longer term. Sell the stocks, take the capital loss, and invest in an ETF in the same sector to maintain your exposure. Later on (at least 30 days) you can sell the ETF and reinvest in your stocks. Or, you may decide to stay with the more diversified ETF. It's your choice. Not only will these strategies help reduce grumbling at this time of year, they'll also help increase your long term after-tax rate of return on your portfolio.

Howard Atkinson, CFA, CIMA, is author (with D. Green) of The New Investment Frontier: A Guide to Exchange Traded Funds for Canadians. He is also the National iUnits Marketing Manager at Barclays Global Investors Canada, Ltd. Phone 416-594-4404.

COPYRIGHT 2002 Money Digest
COPYRIGHT 2002 Gale Group