With Tax Time Nearing, Remember the Advantages of ETFs

One of the biggest trump cards exchange traded funds hold over their actively managed mutual fund rivals is tax efficiencies.

Assuming a mutual fund manager can deliver winning stock picks, a dubious prospect considering recent data highlighting just poorly active managers fare in beating their benchmarks, when those winning stocks are sold the tax tab is passed onto the fund’s investors. That makes for a higher cost of ownership, but the vast majority of ETFs spare investors the annoyance of taxable capital gains distributions. [Active Funds Lag Passive ETFs]

“Most ETFs seek to track indices that have very little turnover during the year and thus amass far fewer capital gains than an actively managed mutual fund would. For example, market cap weighted Vanguard 500 Index (NYSEArca: VOO) has a turnover rate of 3% that is well below the Lipper large-cap core mutual fund average of 67%,” said S&P Capital IQ in a recent research note.

The research firm also notes that although the iShares S&P 500 Value ETF (NYSEArca: IVE) is rebalanced annualy using booking value as a means of delivering investors a portfolio with a value tilt, “has a turnover rate of just 26%, well below the 59% Lipper large-cap value mutual fund peer average. Neither VOO nor IVE expects to incur a capital gain this year.”

S&P Capital IQ rates IVE and VOO overweight.

Capital gains distributions can appear with bond ETFs. Due to steadily rising bond prices over the past several years, fixed income portfolio managers have had fewer tax loss harvesting opportunities with which to offset their winning selections. Additionally, favorable interest rates have allowed corporate issuers to sell new debt and use the proceeds to retire old debt at above market prices, creating a taxable event. [Talking ETF Taxes” Capital Gains in Bond Funds]

“Many fixed income indices are rebalanced monthly, taking into consideration numerous market changes including cash flows from coupon payments, new bond issues, and bonds that have been called or paid down early. As such, fixed income ETFs that try to closely track an index tend to have higher turnover rates than equity ETFs. For example, Vanguard Intermediate-Term Bond Index Fund (NYSEArca: BIV) has a 70% turnover rate,” according to S&P Capital IQ.

Still, BIV charges just 0.1% per, which makes the ETF less expensive than 89% of rival funds, according to Vanguard data. S&P Capital IQ rates BIV overweight.