Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax-Wise Investing Week on Morningstar.com, and today we're talking about how to maximize your taxable accounts and the role that ETFs can play.
I'm checking in with ETF director of research Paul Justice to give us some tips about incorporating exchange-traded funds in your taxable portfolio.
Thanks for joining me, Paul.
Paul Justice: Great to be here.
Stipp: We do know that ETFs are a tax-efficient investment type, and I think that a lot of times we'll say that this is a kind of investment that you could put in a taxable portfolio and get a little more efficiency than maybe some other investment types. But it's not exactly clear to a lot of investors why ETFs are more tax-efficient, perhaps, than mutual funds. Can you walk us through that?
Justice: So, really when we're making this assumption, comparing ETFs to mutual funds for tax efficiency, what we're talking about is equity ETFs versus equity mutual funds. It's true that equity ETFs tend to be more tax-efficient. Why is that? Most of them are index funds. Index funds tend to be more passive in nature, have very low turnover. So that's one reason why they are very tax-efficient.
The other one--and this is kind of the cherry on top of all that--is this creation-redemption process that ETFs go through, which causes them to incur fewer capital gains, if any at all, over the lifecycle of the products. So yes, it's true, they are more tax-efficient from a capital gain perspective.
Stipp: The other thing I hear you folks often talk about, however, is that ETFs are a look-through type of investment. So, if you own fixed-income (bonds), if you have dividend-paying stocks, it doesn't mean that you're not going to get taxed on that income, correct?
Justice: Right. These are not Cayman Island funds; these are ETFs. They're just mutual funds giving you access to it in a different way. The IRS is making sure that no matter what you have, you're still going to pay taxes on it according to that asset class. If it's gold, and you sell it, you're going to get taxed like you owned a collectible. If you own futures contracts, you get taxed like you own futures. Hence, owning equities tends to be a very tax-advantaged way to get some good performance over a long period of time because we tax capital gains at lower rates.
Stipp: When you look at, though, a bond ETF, for example, compared with a bond mutual fund--even though you still are going to have to pay tax on that income--do you see that there is still some tax efficiency in the bond ETF versus the open-end fund?
Justice: Not really. So, most of the tax efficiencies go away when you're talking about fixed income. First of all, most of the tax implications are going to come from the fact that you're receiving interest income. So it's not a lot of capital gains most of the time.
Second of all, when there are capital gains, usually the ETF is going to have to incur them in the same way that a mutual fund is. If you're going to target some sort of maturity or duration, you have to keep selling bonds within the fund. That gets gains.
Stipp: You mentioned gold and futures before. I know that there are some other things that you need to keep in mind with specific types of ETFs, and you've talked about this in some articles [on Morningstar.com]. Where might you run into some tax quirks when you are investing in the ETF space?Read Full Transcript
Justice: Really when you venture outside of the protection of the 1940 Act. This is a securities law put in place to protect investors. A lot of things have come along in the ETF space that don't fall into that bucket. Commodity funds are largely there. So, anything that's going to have futures-based investments or underlying physical commodities, those are the big problem areas.
Stipp: So, I want to talk to you about some [investment ideas]. You have a list of some of your favorite ETFs for portfolio builders. So, for strategic investors; these are the folks who find an asset allocation that works for their time horizon, and then they want to find good investments to fill out that allocation.
Among those portfolio-builders, what do you guys look for when you are trying to find a good fund, and what are some of you favorites there?
Justice: When we are going to look for a fund for these portfolio-builders, and we want to keep an eye on tax efficiency, first we're thinking, what are we going to put in the taxable part of our accounts? We're going to stick with equities, mainly, if we're staying with ETFs. I want to get some broadly diversified, low-turnover funds. So that way I am getting exposure to the whole market at the lowest possible cost and minimizing the chances that I am going to get any capital gain tax. We'll probably take some divided tax. I'll be glad to pay that; it's at a lower rate.
So, I usually start out for the U.S.-based investor with Vanguard Mega Cap. So this is going to give me access to the 300 largest stocks in the U.S. market. That's a great way to start.
Round it out, then, with either a value pick or a smaller-cap fund pick, and just finish up the exposure there. If I have still got room in the taxable accounts, I can think about a dividend strategy or something at that point, but not until I have got the base exposure covered.
Stipp: OK, and what if you wanted to look overseas, do you have any ideas there?
Justice: Sure. So, we go with Vanguard Emerging Markets fund usually to start out with that type of exposure: VWO. It is one of the lowest-cost ways to get into these markets. It's been very tax-efficient and very low tracking error in that fund.
We also look for EFA [iShares MSCI EAFE Index] as our EAFE fund, so that's basically a Europe, Australia, Far East fund. That's going to give us the developed-market exposure overseas, as well, and with that emerging-market fund, balances the whole thing out.
Stipp: I know that you folks run the ETFInvestor newsletter and you have different types of portfolios there, and one of the things that you do in some of your portfolios is you're more tactical, and you look out and say, where are the opportunities right now?
So, for those investors who want to root out some opportunity in the market, some undervalued securities, what have you been looking at recently in the ETF space?
Justice: We recently started publishing six new strategy portfolios, where we're looking at momentum and value factors. Some of these momentum signals have been changing over the course of the last month, as you can imagine. We had great performance through January. You are getting out of things now that the signals were strongest with: consumer staples, utilities, a lot of the income-producing factors. Now you're getting into things that are going down in the smaller-value section of the style box, some things that are higher beta.
So it's a very dynamic time right now. We're going to have quite a bit of turnover in the portfolio, I anticipate, in the next couple of weeks, kind of moving down on the size spectrum and moving out in the risk profile.
Stipp: All right, Paul. I'll certainly look forward to checking in with you on some of those strategies in future videos, but thanks for joining me today with some of the tax strategies behind ETFs as well as some of your top picks.
Justice: Thanks, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.