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Must-Know Facts About ETFs and Taxes

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

It's Tax Relief Week here at Morningstar.com. I'm here with Paul Justice. He is the director of North American ETF research. We're going to take a look at what ETFs make sense for taxable account and how they compared to some other investment products out there.

Paul, thanks for joining me today.

Paul Justice: Oh, my pleasure.

Glaser: So, I think that a lot of people know that ETFs are generally a pretty tax efficient vehicle, but are they dramatically more tax efficient than some other investments that people might be considering, like a traditional mutual fund index fund?

Justice: Well, it's interesting you bring that up. For the most part, ETFs are going to be index mutual funds. The F in ETF is still fund, and most of them are going to be the passive sort of index, at least where all the money is right now, that's where you're going to find it. And that's where most of the tax efficiency of ETFs come from. The passive nature of the fund itself--the index.

Now, if you compare an index ETF, say the S&P 500 versus an S&P 500 mutual fund, there is a good chance you're going to get a slight improvement on the tax efficiency of the ETF, so long as you're performing good behavior on the behalf of the investor yourself. It's very similar to the argument, the NRA makes about guns. Guns don't kill people, people kill people. If you're going to day trade an ETF in your taxable account, you're going to hit with a lot of taxes, but that's going to be a user problem not a fund problem. If you're going to hold on to it for a very period of time, ETFs can be a very low cost, tax-efficient manner if you wish to get that exposure.

Glaser: So, if I have a portfolio of index mutual funds right now, does it make a lot of sense to sell all of those and replace them with their ETF equivalents just for that tax advantage?

Justice: No, if you're going to go through that trouble--chances are, let's say, you've held those funds for a long period of time. Most index investors are buy-and-hold types, either you're going to sell those or you're going to generate that taxable gain. It's going to wipe out the minuscule difference that you're going to get from going to the ETF structure.

Now, on the flipside, if you do have some losses built up there, that could be a good tax-loss harvesting strategy to sell out some of those Index mutual funds, realize the loss and allocate it to a similar but different strategy, say switching from an MSCI Index to a Russell Index or vice-versa. Dow Jones and S&P would count towards that too--to give you similar exposure, but to reap those losses and get your exposure set back with a cost basis that's neutral.

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Glaser: Now inside of the realm of those passive funds, we've seen an explosion of ETFs that are a little bit more active. Are those all necessarily efficient or does it really matter of what the actual funds are buying and selling?

Justice: No. The real tax efficiency from ETFs comes from the action of other investors in the fund or the fund flow aspect. With a lot of people buying and then selling out, if you are in a mutual fund structure, you make get hit with a tax bill even if you don't sell it. With an ETF that's typically not going to happen. You neutralize that component of the taxation. But if within the ETF portfolio itself, if there is a lot of rebalancing that goes on or a lot of changes of the constituents, you are still going to have the potential to generate taxable gains there at the same level that you'd see in the mutual fund--that doesn't go away. The ETF is just a look-through vehicle; it's not this magical tax evading vehicle.

Glaser: Now, let's talk about commodities. Certainly, that's been an area that's on a lot of people's minds. Tax on commodities is sometimes a bit of a murky subject. Do ETFs make sense to get that commodity exposure in a taxable account?

Justice: That's going to depend on the investor. So every time we say there is all this tax efficiency with the ETFs, we're really focusing in on the traditional funds that people are used to, your equity accounts, your passive equity accounts, especially. Futures themselves or commodities are going to have their own unique set of taxation rules that are going to apply to the ETF vehicles as well. So, if I am going to get United States Oil, I will use this one as an example, and it's buying these futures contracts, I get taxed like I own the futures contracts.

What that means is, even if I don't sell my fund at the end of the year, I may have to pay a tax bill if there is a gain--60% at the long-term rate, 40% at the short-term rate. Now, the fact that you have to pay taxes is one thing that catches investors off guard, but the second thing is they have no idea--they were never buying futures before in their own account anyway. So just going through that process can be pretty cumbersome.

One thing you can do to avoid some of those complexities if you are using commodity investments, if you go with ETNs instead of ETFs, so exchange traded notes, which are those unsecured debt obligations that track this index and give you good exposure there. There can be some favorable tax advantages there because you can treat it just like you would a regular stock or something like that.

Glaser: With the ETN, you are introducing some counterparty risks that you have to hope that the issuer will be there to back that note. Is that something that you worry about or does the tax efficiency really outweigh any of those potential risks?

Justice: Yes, I worried about it in 2008. I am not really worried about it right now. It's a very short-term risk, it's something that what we say is, you have the ability to put that ETN back to the bank on any given day, which really kind of mitigates a lot of that risk. Chances are banks are not going to be healthy one day and then bankrupt the next. There's going to be some lead time for you to get out of that investment. So I am a lot more comfortable with it than a lot of people are, and I think most of my colleagues feel the same way. ETNs are relatively safe investments today so long as you're aware of when volatility strikes, what financial institution is backing it.

Glaser: Master Limited Partnerships, or MLPs, are a place that people have been looking for yields, but then they get hit with these K-1s at the end of the year and might be confused when they are actually filing their taxes. Is there an exchange-traded product that helps that in a taxable account?

Justice: Absolutely. Now, this is a fascinating part of the ETF landscape, I think. We've seen a lot of MLP products actually come out over the last two years that are giving people access to MLPs now without having to deal with the complexity of a K-1 statement instead of their traditional 1099 Form.

Now, the upside is, it's easier to file taxes with these. The downside is MLPs are actually really tax efficient investment vehicles all on their own, which some of those tax advantages go away when you put it in an ETN or an ETF wrapper, but you don't run into headaches--you can now put these things in your retirement account, sleep at night not worrying about tripping these UBTI clauses that would make your whole IRA taxable. That worry, it's gone.

So for a little bit of extra cost for that individual investor you are getting access to something without the tax headache, which turns out to be a really good complement to a stock-bond portfolio. It's had really low correlation with those returns. So really a nice piece of asset allocation to add to the mix, either in a 401(k) or a taxable account.

Glaser: So it sounds like as long as the underlying of an ETF or an exchange traded product is tax efficient, you're going to get that tax efficiency in your taxable account?

Justice: That's right.

Glaser: Paul, thanks so much.

Justice: My pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser.