Enter the exchange-traded index fund. An ETF that tracks an established index does not distribute significant capital gains the way a traditional mutual fund might. For one thing, an index does not change very much, if at all. Without the need to change what the ETF holds, the lack of trading activity means there are less distributions to shareholders for tax consequences. Similarly, outflows force the sale of securities in mutual funds; the redemption process for an ETF is different than the process for a mutual fund whereby the ETF structure enhances tax efficiency.
According to a 2012 study at Morningstar, the 5-year average distribution for a large-cap stock blend mutual fund was nearly 2%. ETFs? 0%. For one who might have $200,000 in large stock mutual fund exposure, that’d be four thousand dollars in capital gains distributions annually. Five years of holding the large cap fund would cost $600 per year at a 15% capital gains rate for a total of $3000. Simply selecting iShares S&P 500 (IVV) in one’s brokerage account would eliminate the levy.
Outside of the stock arena, distaste for capital gains distributions morphs into disdain for the taxation of interest income. Those who find themselves in a very high marginal tax bracket might do well to skip straight to the no-tax world of municipal bonds. It is true that the rapid rise in interest rates that followed the Fed’s tapering announcement in May of 2013 served to punish munis mercilessly. SPDR Nuveen Muni Bond (TFI) logged -3.9% last year.
However, last year’s muni bashing created opportunity for those who wish to pursue income free from federal taxation. TFI quickly recovered a technical uptrend, already garnering 4.5% year-to-date. For an investor in the 35% tax bracket, the taxable bond equivalent yield is 4.0% — a return that simply cannot be matched by intermediate-term investment grade bond funds. Longer-term munis in Market Vectors Long (MLN) have also been winners.
Obviously, investing in anything for tax benefits alone is likely to bite in unexpected and undesirable ways. Nevertheless, one can consider the favorable spreads that munis offer the high marginal tax bracket investor. A fund that I like for taxable as well as non-taxable accounts is PIMCO Short-Term High Yield (HYS). It may offer a 4.3% yield with relatively low risk. Now consider Market Vectors Short-Term High Yield Muni (SHYD) with a projected 3.9% yield net of fees. In a 35% marginal bracket, a 6.0% taxable equivalent yield makes SHYD an attractive prospect.