Best Place for Portfolio Turnover: Within an ETF
One of the reasons ETFs have a reputation for being tax efficient is that there tends to be less portfolio turnover in index-based strategies than in active strategies. But not all ETFs have absolutely low levels of turnover. If there is a good place to have turnover, I would argue it is within the ETF structure, because of the in-kind transfer mechanism described above.
Some of the new “smart beta”-related strategies incorporate rules-based rebalances back to a sense of relative value—and these rebalances can create 30%–40% turnover, or more, on an annual basis.
Some of the tax consequences of these in-fund portfolio rebalances can be offset via the efficient management of the fund provided by the functionality of the creation and redemption process. This creation/redemption process is a key element to what makes ETFs tax efficient and why I think they will remain so, despite the market hitting new all-time highs.
Not All Markets Allow In-Kind Transfers
Not all markets can be as tax efficient as U.S. equities. The key to U.S. equity tax efficiency, in my mind, is the fact that most of the execution of the underlying components of ETFs happens outside the fund structure, by the authorized participants.
Not all markets possess this in-kind transfer attribute. For instance, not all fixed income securities can be transferred in-kind. Not all emerging market countries allow for in-kind transfer of securities. In fact, MSCI even cited this mechanism as one of the reasons it qualified South Korea as an emerging market—as all other developed market countries do have this in-kind transferability (as we discussed in this previous blog post).
Focus on the Bottom Line This Capital Gains Season
One portfolio manager in Texas I spoke with this year said to me that his clients no longer have losses built up in their portfolio—a very nice problem to have, one can say. But this makes portfolio rebalancing tougher for this advisor, because his clients do not always like to see the capital gains taxes that come with incorporating a portfolio rebalance.
This is where some of the ETFs that incorporate a relative value rebalance in their methodology can manage valuation risks—but in a tax-efficient format within the ETF structure. The U.S. mid- and small-cap segments, which have some of the strongest gains this year, are a prime area to consider such relative value-based rebalancing ETFs.
Important Risks Related to this Article
Neither WisdomTree Investments, Inc., nor its affiliates, nor ALPS Distributors, Inc., and its affiliates, provide tax advice. Information provided herein should not be considered tax advice. Investors seeking tax advice should consult an independent tax advisor. Some mutual funds have an objective of tax efficiency.