By Patricia Oey
While ETFs are generally tax-efficient investment products, there are some strategies investors can follow to minimize the tax liability of their portfolio beyond just using ETFs. Additionally, investors should be aware that certain exchange-traded products are less tax efficient than others. At the Third Annual Inside ETFs Conference hosted by IndexUniverse.com, we attended a panel presentation by financial advisors entitled "ETFs and Taxes: The Issues and Opportunities" to hear some of these ideas.
The first panelist to speak, Curt Lyman, senior managing director at HighTower, started his presentation by saying that rising tax rates are inevitable, given the current deficit situations in public budgets. He strongly advocates the use of ETFs as investment vehicles, which tend to be more tax-efficient relative to their mutual fund cousins due to ETFs' in-kind creation and redemption structure. He also highlighted that over the past few months, ETF providers have launched a number of products that can help investors better execute tax-planning strategies, and he expects this product category to continue to grow in the near term. Earlier this year, iShares launched a family of municipal-bond ETFs that will liquidate and return assets to shareholders at a target date, the first of its kind. In general, municipal-bond ETFs are far more liquid than individual muni bonds, and serve as good building blocks for bond ladders and more effective cash flow planning.
Morningstar's take: We are also excited about the proliferation of new products in this category. At the same time, investing in muni-bond ETFs is not without risk, especially at this time when municipalities and states struggle to balance their budgets. An interesting product launched last year in December is the actively managed PIMCO Intermediate Municipal Bond Strategy (MUNI). For a fee of 0.35%, investors can have access to a portfolio that will capitalize on PIMCO's credit analysis expertise.
Lyman continued his presentation by reviewing certain ETFs that receive special tax treatment. Leveraged and inverse ETFs use options, such as swaps and forwards, which are settled through cash transactions. When leveraged and inverse ETFs suddenly face large amounts of net redemptions, the fund sponsors could be forced to sell its options instruments, which could result in capital gains distributions--just like mutual funds. He also reminded the audience that gains on the sale of precious metals ETFs such SPDR Gold Shares (GLD) are taxed the same as collectibles, at a maximum of 28%, regardless of an investor's holding period.
Morningstar's take: While ETFs have provided access to asset classes previously inaccessible to the smaller investor, it is important to understand that different asset classes can have different tax treatment, even within an ETF structure. During last year's tax season, ETF strategist Paul Justice wrote a detailed article explaining the tax issues for some of the less traditional ETFs, such as limited partnership ETFs and grantor trust ETFs.
The next person to present was Edwin Baldridge III, president of Baldridge Asset Management. The focus of his presentation was tax-loss harvesting. First, he quickly covered the basics: Long-term capital loses offset long-term capital gains, short-term losses offset short-term gains, carry forward capital losses can offset ordinary income by $3,000 a year, and excess losses can be carried forward until death. Capital losses can also reduce capital gains from the sale of businesses or real estate. He then brought up the IRS Wash Sale Rule, which says that investors cannot realize capital losses by selling a stock, and then buying a "substantially similar" security again within 30 days. He noted that given the proliferation of ETF products, investors can sell a security to realize a capital loss and replace that security with another that is not necessarily "substantially similar." He provided the following examples: 1. Replace an ETF with one with a similar strategy but that tracks a different index (iShares S&P 500 Index (IVV) for Vanguard Large Cap ETF (VV) ); 2. Replace a stock with a sector ETF (ExxonMobile Corporation (XOM) for Energy Select Sector SPDR (XLE) or Vanguard Energy ETF (VDE) -- XOM accounts for about 18% in each of the two portfolios); and 3. Exchange a mutual fund for an ETF with a similar strategy.
Baldridge concluded by mentioning some risks to tax-loss harvesting strategies, which include trading costs, changes in ETFs' premium and discounts (which can be a source of hidden costs), and unexpected distributions from ETFs. He also said that investors should not wait until December to think about tax-loss harvesting strategies and suggested that investors incorporate these strategies when they rebalance.
Morningstar's take: We recommend investors consult with their tax advisor before executing these trades. The Wash Sale Rule is explained in the IRS Publication 550, and at this time, the IRS has not fully clarified what isn't a "substantially similar" security.
Looking forward, ordinary income, capital gains, and dividend income taxes will likely reset at higher rates starting in 2011. And we think there is a risk additional tax burdens could be coming our way, given the current federal deficit situation, a possible public health-care program, and looming entitlements. It is a dynamic situation and one in which all Morningstar analysts are monitoring carefully.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.