Lower Taxes on ETFs

Holding ETF shares in taxable accounts can lead to a lower annual tax bill than if you owned a similar open-end mutual fund. The tax benefit is a byproduct of the authorized participant (AP) arbitrage mechanism described in Chapter 3. The next few paragraphs explain a specific tax advantage inherent in ETFs and other exchange-traded portfolios.

As outlined in Chapter 2, APs are the only investors that can deal directly with a fund company. An AP turns in a predetermined portfolio of individual securities and is issued one creation unit by the fund company. As the fund manager brings in the new securities from the AP, each issue is assigned a cost basis based on the market price of the security when it came into the fund.

Figure 4.1 illustrates how an ETF manager assigns a cost basis to new shares of stock coming into a fund. The ETF is SPDRs S&P 500 and the stock is Microsoft (symbol: MSFT). After an AP turns in MSFT stock to a fund as part of a basket in exchange for a creation unit, whatever the market price of MSFT was at the time the shares booked into the fund becomes the cost basis to the fund.

In the Figure 4.1 example, MSFT was trading at $30 per share at the time an AP turned in shares. These new MSFT shares are added to the already existing shares of MSFT stock in the fund, but accounted for separately for tax reasons. Those shares are added to the manager's book on MSFT at $30 per share. Every time stock comes into an ETF, those shares are given a separate cost basis and added to the manager's book.

AP turns in stocks and receives a Creation Unit.

MSFT is at 30

AP turns in MSFT stock

S&P 500 SPDR

MSFT

10,000 @ 40

MSFT

10,000 @ 35

MSFT

10,000 @ 30

MSFT

10,000 @ 28

MSFT

10,000 @ 25

MSFT

10,000 @ 23

Manager's Book

Manager's Book

Figure 4.1 Establishing Cost Basis in an ETF

Source: Portfolio Solutions, LLC

S&P500 SPDR

AP receives this lot of MSFT

AP turns in Creation Unit and receives stocks.

Manager's Book

Figure 4.2 Eliminating Low-Cost Basis Stock in an ETF

Source: Portfolio Solutions, LLC

When an authorized participant redeems a creation unit, it receives common stock back based on the NAV of the fund at the time. The shares the AP received, however, are typically not at the same cost basis in the fund manager's book as the shares that were turned in. The ETF manager can issue different shares, which may have a lower cost basis than what the AP originally turned in.

As Figure 4.2 illustrates, there are different tax lots of MSFT stock on the manager's book. The manager chose to distribute the $23 tax lot of MSFT shares to the AP. The manager did not send out the $30 tax lot that was established when the shares came in. If the manager issues low-cost basis stocks back to redeeming authorized participants, the unrealized capital gains in the ETF are practically eliminated.

Table 4.2 illustrates the tax advantage of ETF shares over a traditional open-end mutual fund. In the 1990s, when large cap stock returns were up significantly, S&P 500 SPDRs issued minimal realized capital gains to investors, whereas the Vanguard 500 Index Fund issued capital gains to investors each year.

The redemption of creation units by authorized participants creates an important tax benefit to the holders of ETFs in taxable accounts. It rids a fund of gains that may otherwise eventually have to be distributed to taxable shareholders, and they would have to pay taxes on those gains. The selection of tax lots is perfectly legal and is practiced every day.

To illustrate the power of the ETF tax benefit, we need only to examine 2006. The stock market was up about 15 percent for the year. However, very few U.S. equity ETFs pay any capital gains and those that did were smaller funds, and they paid a minimal amount.

Table 4.2 Capital Gain Distributions as a Percentage of NAV

S&P 500 SPDRs

Vanguard 500 Index

1994

0.00%

0.47%

1995

0.02%

0.23%

1996

0.16%

0.36%

1997

0.00%

0.66%

1998

0.00%

0.37%

1999

0.00%

0.74%

Source: Bloomberg, Morningstar Principia

Source: Bloomberg, Morningstar Principia

The creation and redemption process allowed most of the unrealized capital gains within ETFs to be erased.

The washing of capital gains does not always work perfectly. ETFs may be forced to make an occasional capital gains distribution because they must still sell stocks for cash that are taken private or bought by another company for cash. In addition, the exception to the rule on tax benefits is Vanguard ETFs. Vanguard funds are traditionally tax efficient. However, Vanguard ETFs are a share class oftheir open-end funds rather than a stand-alone investment vehicle. As such, all share classes of Vanguard funds are treated equally in regard to taxes. Open-end share class investors have the same level of taxable distributions as ETF share investors. Since open-end shares represent over 90 percent of the assets in a fund with an ETF share class, there is a chance that Vanguard ETFs will ultimately not be as tax efficient as they would be if the ETFs were standalones, particularly in the style funds such as the small cap value index.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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