The ETF Edge in an Uncertain Tax Climate

Scott Burns: ETFs and tax efficiency. Hi, there. I am Scott Burns, Morningstar's Director of ETF Research, coming to you live from Morningstar's premiere ETF Invest Conference.

Joining me today to talk about ETFs and how to really employ the tax efficient nature of these funds in your portfolio is Mark Balasa, who is Co-CEO of the RIA firm Balasa, Dinverno, Foltz.

Mark, thanks for joining me.

Mark Balasa: My pleasure.

Burns: Now, Mark you were one of the early adopters of ETF strategies and ETF portfolios, and we've discussed that really what drew you to those products was their tax efficiency. What is it about the ETF that helps in your practice deliver such a tax-efficient product for your clients?

Balasa: That's a great question, especially given perhaps where tax rates are going to be headed, which is up. We started using ETFs, to your point, back around 1999, 2000, and if you think back to that point in time, there was a lot of volatility in the market. And what happened is, we had several asset classes where we had actively managed funds that had big distributions, and yet the fund went down that year, so we lost return. We had negative returns. We had a gain to pay, and so...

Burns: ...And nobody likes that. To hear "hey, we're sorry, we lost your money. Here is the bill."

Balasa: Precisely. So, when ETFs, they came out in '94, but they really started – the lineup started expanding around 2000. We said, gosh, can we implement some of these asset classes with fewer surprises? Well, we got an added benefit of actually getting lower expenses, but also we had much more control over when we're going to take the gains as opposed to when the fund company was going to give the gains, and so for us that was a natural addition to the portfolio.

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Burns: You started using ETFs in 1999 and here we are in 2010. Can you quantify how much money you think you've saved your investors over that time through that tax efficiency?

Balasa: It's a good question. It's difficult to measure, because you have to keep track of what you would have done versus what you are doing, but what I can tell you is that, periodically, we get questions from clients, especially if there is turnover in the portfolio: "Well, what did that cost me?" And so this is anecdotal, but if you look at a portfolio from the timeframe of about 2007 to 2009, when there was a lot of commotion in the portfolio, in our internal measuring, we think we saved about a third of the tax bill.

So, if you think about that in basis points, it could be as much as a 100 basis points. That won't happen in all circumstances, and that number is going to come down the longer the portfolio is static without cash flows, but again in trying to take a run at answering the question, that's what we came back with.

Burns: Well, I think, as you alluded to, one of the clear fears on advisors' and investors' minds, right now is the rising tax environment. With that tax efficiency and a rising tax environment, would you expect those saving to grow more, or is it still a third of tax, but it's just larger tax bill?

Balasa: It's somewhat contingent upon cash flows, because if there is no cash flows and you harvest losses and keep resetting your basis, then it gets more difficult to be tax efficient, but if there is cash flows, in or out, especially in, of course, you can extend that period of greater tax efficiency in the portfolio.

Burns: What are your thoughts on tax rates? It is on everyone's mind. I feel like I should have just had a panel on taxes 2011, what's going to happen? Because it comes up, even in the emerging market panel, it came up.

Balasa: No, it does. It is on everyone's mind. It, obviously, has been in the papers a great deal lately with all the debate.

For us, as we look at it, as I said earlier to someone today, we aren't actually proactively making change in the portfolio now, because it's too hard to second guess what Congress might or might not do. But when you think about it going forward couple of things come to mind. One is, when you rebalance, as tax rates go up, assuming that's what happens, the calculus with when you rebalance, and how far you rebalance is going to be shifted, because now it is going to cost more.

Number two, you think about big picture asset classes. Large growth inherently has fewer dividends, it's more tax efficient, if you will, than let's say small value. So the asset classes are going to be impacted very quickly I would think as legislation comes out and there is a sense of where things are headed. So, all that's going to have to be cooked into how you rebalance and how you set your strategic allocation going forward, especially in taxable accounts.

Burns: And when I get asked that question I say, well, it is hard to predict what they are going to do, but the one thing that you can act upon now is to increase your tax efficiency regardless, because the tax rates today, the tax rates tomorrow, there is no magic end-around that people are really looking for. You have to manage your tax liability as best you can, no matter what. And if taxes go up, in a lot of ways, I think, you are right, they are going to impact some asset classes, but it's kind of a slippery slope of, how do I change everything around when taxes rise, taxes fall. That's fairly ubiquitous concept over investing history.

Balasa: It is. I mean if you think about taxes and generally look at it more globally, there are some ways you can permanently eliminate taxes, there are some ways you can defer taxes, and there are some ways you can time taxes, right.

Each of those are kind of different strategies and some of this is outside of ETF. There are things like charitable strategies, step up in basis, et cetera. But when you look at it in its totality, there are opportunities, and those are all going to shift to your point, but specifically on the investment side, it's too early to make any concrete decisions yet.

Burns: So, just keep things efficient, keep things low cost, and you'll be in the best position whatever Congress does.

Balasa: Control the things you can control.

Burns: Exactly. Well, Mark, thanks for joining us and sharing your insights.

Balasa: My pleasure.

Burns: And I am Scott Burns with Morningstar. Thank you.