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Are Index Funds Tax Efficient?

02/15/2019

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Active management has come under scrutiny for various reasons, leading investors to opt increasingly for passive index funds to deliver efficient returns. However, tax optimization is an important aspect of asset management that is often overshadowed by performance and fee considerations. This leads us to the more important question – are index funds tax efficient?
Confirming that index funds are tax efficient is an important exercise, especially for more affluent investors with larger, more complicated tax exposures. It is also important to establish a clear concept of efficiency, because true economic efficiency can mean totally opposite things for investors in different circumstances.
The relative strengths and weaknesses of index funds must be understood in the context of an individual or family’s financial plan.

Setting the Stage: Defining Index Funds

Index funds are pooled investment vehicles designed to track the performance of securities indexes such as the S&P 500, the MSCI Global Index, the NASDAQ 100 or the Barclay’s Aggregate Bond Index.

By pooling assets and owning shares of the entity created by that combined wealth, investors can gain indirect exposure to a wide range of securities owned by vehicles such as ETFs and mutual funds. ETFs trade on an open market in the same manner as stocks, and their price is dictated by supply and demand. Mutual fund shares are issued to each new shareholder by the fund itself, then redeemed for cash from the fund, rather than sold on an open market.

These structures have subtle, yet important differences, but both allow for efficient indexing.  Approximately 30% of all assets under management in mutual funds and ETF’s are tied to an index of some sort, and that share is steadily growing.

Index fund assets are expected to surpass actively managed assets by 2024, driven by low associated costs, improving educational resources for do-it-yourself investors, and growing skepticism of the value created by active managers.

Looking at Fund Allocation and Capital Gains

Both ETFs and mutual funds must pay taxes on realized capital gains held by the fund, and these usually result from rebalancing, index reconstitution, or position closure related to share redemptions.

Index fund allocation is required to closely resemble that of a target index, which requires periodic adjustments to holdings as the value of constituent securities fluctuate relative to each other over time. Indices also periodically constitute their member securities, leading the tracking funds to transact securities in response.

Any time securities are sold for a price in excess of the cost basis, the fund must pay capital gains taxes on that appreciation, a characteristic common to both ETFs and mutual funds. However, mutual fund structure lends itself to more taxable events, because they often must liquidate securities in exchange for the cash used for shareholder redemptions. The capital gains taxes assessed in these circumstances are passed along as an expense to existing holders, which can force newer shareholders to pay for appreciation from which they never benefited.

Active vs. Passive Management Strategies

While these tax liabilities are undeniable, index funds do enjoy some tax-related efficiencies relative to actively managed alternatives.

Passive strategies usually have much lower turnover than actively managed funds, thereby reducing the frequency of taxable events for index funds. The severity of this effect is obviously influenced by fund strategy and market conditions, but the average tax drag is estimated at 1.57% annually for actively managed funds.

Similarly, not every index requires the same amount of rebalancing or reconstitution, so some passive funds are more tax efficient that others in this regard.

How Active Management Creates Tax Efficiency

Despite the drags caused by more active strategies, these effects can be neutralized or partially offset by something called tax loss harvesting.

At any given time, some fraction of positions in a portfolio are likely to be delivering negative returns relative to their cost basis, and the sale of those securities generates a capital loss that can be used to reduce the tax liability from gains elsewhere in the portfolio.

Rebalancing and Reconstitution Strategies

Rebalancing or reconstitution can afford fund managers opportunities to strategic position closures that are most advantageous from a tax perspective, or there could be opportunities to replace one security with another highly-correlated position, thereby locking in losses without affecting forward performance.

Active Strategies and Portfolio Management

Some index funds are designed specifically to maximize outcomes with respect to capital gains tax exposure, but they are generally more limited in this regard than actively managed funds.

Active strategies allow more allocation freedom, and hedges are often built into portfolios to drive outperformance in all market conditions, creating more opportunities to strategically select under-performing stocks.

Estimates vary, but tax loss harvesting can add 35 to 200 basis points in annual net returns for the fund.

Combining Passive and Active Strategies

Investors with sufficiently high savings can consider indexing strategies that combine the tax efficiency of active management with the principles supporting passive strategies. Separately managed accounts (SMA) utilize professional management services, and they involve directly holding securities, and they can be indexed-tracked in the same way that pooled asset portfolios are.

Indexed SMA managers can opportunistically engage in tax loss harvesting without violating the allocations that are dictated by target indexes, and these losses can be used to offset gains from any other asset class in the current year or carried forward future years.

Why Your Other Assets Matter

Investors must consider their entire financial plan to understand the role and suitability of index funds from a tax efficiency perspective, because there are pros and cons to any popular strategy or product.

Special Tax Considerations

Investors with highly diversified asset portfolios that contain alternatives such as private equity, income-generating real estate, or venture capital interests are likely to benefit from special tax considerations that are beyond the scope of index funds, which are designed to be simple and streamlined.

Tax Efficiencies According to Investor Types

Investors should also consider the type of tax efficiency that makes the most sense for their assets and income.

  • Younger investors who are still accumulating and are not closing out many positions are more likely sensitive to income tax liabilities, fund management expenses, and less concerned with offsetting realized long-term capital gains.
  • Many households have asset concentration in real estate and retirement accounts such as 401(k), 403(b) or IRAs.
  • Qualified retirement accounts are not subject to capital gains, but are rather tax deferred through accumulation, then distributions in retirement are taxed as ordinary income. Assets housed in Roth accounts grow tax-free, and qualifying withdrawals are not subject to any taxation, so capital gains tax offsets would be largely irrelevant to scenarios where qualified retirement accounts are important.

Investors who are selling a home or private business that has appreciated significantly are likely to be anticipating the greatest financial windfall of their lifetime, and capital gains taxes could put a material dent in the net returns on their hard work and diligent savings over the years.

A complimentary securities portfolio designed to deliver capital gains offsets could have a major impact on the outcome of their overall plan.

Ramifications on Retirees and Affluent Investors

Retirees or affluent investors with passive income streams may have their lifestyles largely locked in following years of building an asset base designed to produce cash flow that supports daily living. Allocation designed to minimize income taxes could have major implications for travel, lifestyle, gifting or health care.

Some retirees will also need to consider the variations in tax consequences among index funds themselves. Equity funds have totally different ramifications from bond funds, and municipal bond funds can vary greatly from corporate or sovereign bonds.

In a Nutshell: Are Index Funds Tax Efficient?

For some purposes, index funds offer a highly tax efficient solution, but there are other circumstances in which they are not ideal, it totally depends on the individual plan. As frustrating as that reality might be, there is no one-size-fits-all strategy, and each investor must consider the most significant risks and opportunities available to their holistic financial situation.

Ultimately, in our quest to answer the question – are index funds tax efficient? As a rule of thumb, the most popular index ETFs and mutual funds are very efficient straightforward vehicles, but they will never provide highly individualized tax efficiency.

Larger portfolios with shorter time horizons and lower margin for error and volatility likely require more attention, while early-stage accumulation might be perfect candidates for the lean simplicity of index funds.

In all cases, investors can benefit from using online resources to educate themselves, and trusted financial professionals can be extremely valuable allies when considering options, seeking education or stress-testing different potential strategies.

DISCLOSURES

Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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