In my last post, I talked about how some investors use fixed income exchange traded funds (ETFs) as an investment bridge – a place to put money when moving between managers or making other portfolio changes. Two of the main reasons we see ETFs used in this way are index tracking and liquidity. But there’s another big factor, one that’s especially relevant this time of year: taxes. I talked to one of our experts, BlackRock Managing Director Rob Nestor*, about why taxes are a major consideration when making a move.

Q: Rob, I’ve heard you speak to the “total cost of ownership” when it comes to investing. Most people think of buying a car when they hear this phrase, so how does it apply to a portfolio?

A: When you’re shopping for a car you don’t just look at the sticker price, you also have to consider the maintenance fees, insurance and gas mileage. When looking for the right investment, the same principle applies: you need to look all the costs of ownership.  This includes not only the management fees but also the costs to buy and sell the fund, and the fund’s tax efficiency. Only by looking at the whole picture can you get a sense of what you’re really paying.

Q: Let’s focus on the tax efficiency part. First, what does tax efficiency actually mean? Is it specific to a particular type of investment?

A: All mutual funds and ETFs are susceptible to making an annual distribution of capital gains. When a fund buys and sells securities during the year, it realizes a capital gain or loss on each transaction.  At the end of the year, the impact of these transactions is added up to determine whether the fund generated realized net capital gains or losses.  If the fund is in a net realized gain position, then fund investors will need to pay taxes on the gain in the year it was received, assuming it is held in a taxable account. (If held in an IRA for instance, then the distribution isn’t a concern.)

Q: Let’s explore that a little more. As an investor, you want your portfolio to do well, and “gains” tend to be a good thing. So why are capital gains distributions generally frowned on by most investors?

A: Four reasons. First, capital gains essentially return your money to you early. You get cash when you probably wanted to stay invested. Even though most accounts provide for automatic reinvestment, you have to pay the tax on a distribution whether you reinvest or not. Second, the gain could be classified as short term or long term; it depends on how long your fund held the security that triggered the gain. (For most investors, a short-term gain is taxed at a considerably higher rate than a long-term gain.) Third, the gain is driven by the actions of the portfolio manager, not you, and not directly by the performance of your investment.  This means it’s possible to buy a fund, have it fall in value, and get a capital gain tax bill on top of the loss of investment value. Fourth, and probably most importantly, these distributions accelerate the payment of taxes that otherwise wouldn’t occur until a later date (if at all). Generally, although there are some exceptions (such as increases in future tax rates), accelerating tax payments results in real opportunity cost loss.

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