IRS

Savings on Capital Gains Ease Losses

IRS

Many index fund investors can take some comfort this tax season that they are not paying capital gains on funds reflecting lost value. Both Barclays Global Investors and the Vanguard Group report they have not needed to distribute capital gains to investors in their index funds, and both firms emphasize the advantages of tax-efficient mutual funds and exchange-traded funds (ETFs) during turbulent markets.

Brad Zigler, Head of Investor Marketing and Education at Barclays Global Investor Services, says investors seem to be catching on. "In the environment we've seen in the last year, protection from capital gains generated by others leaving a fund is a significant benefit of ETFs. I have seen, amazingly, a lot of people holding still during these turbulent times. Many have opted to stay the course, and I believe there are two main reasons for this. Number one, people have more information available to them. The analytical tools to measure risk - tools that were once the exclusive purview for professionals, and only for a fee - are now available on the Internet free of charge. Also, investors have had the opportunity to see volatility in the past and they realize that indexing works in the long run by staying the course. I think that mentality has grown because of the democratization of information and the reduced fees charged for ETFs. We would not be in the ETF business unless there had been a secular change of thinking in the marketplace."

Accounting Tactics Play a Major Role

Brian Mattes, Principal at Vanguard, says it is a generally accepted rule of thumb that the tax bite in traditional mutual funds reduces returns by two percent per year. Vanguard avoids capital gains taxes by employing "HIFO" (high-in, first out) accounting procedures. "We sell our high-cost stocks first," Mattes explains, "and balance those losses against gains. In March of 2000 we liquidated a number of stocks and realized substantial losses that we can carry forward for several years. Theoretically, investors today could redeem up to 37% of our S&P 500 fund before one dollar of capital gains would be realized. And such a massive sell-off is unlikely - only 10% of stocks sold off in the month after the '87 crash."

For ETFs, Fund Activity can be More Tax Efficient

The very method by which ETFs are formed and restructured helps contain capital gains.

Zigler explains how an individual's sale of iShares does not generate a tax impact for remaining shareholders: "Take the iShares S&P 500 fund. The holder of the shares sells just the way he bought the iShares - through a brokerage account like any other stock. When shareholders in an ETF decide to exit a fund, they don't deal directly with the fund company and its portfolio. Instead, they find a counter party to buy the iShares on the floor of the exchange." As a result, the tax ramifications are the shareholder's alone, and do not fall on the population of fund shareholders.

Next Zigler explains why ETFs can be more tax efficient than mutual funds: "The creation and redemption activities of ETFs are only undertaken by institutions - the trading houses and specialists themselves. And when they trade, they do not use cash: they use stock as the basis of the transaction. These transactions, then, are a form of barter and as such are not subject to capital gains. That is where the tax efficiency of ETFs arises."

Sometimes an ETF Does Have a Tax Bite

Zigler cautions that investor insulation from one type of capital gains with ETFs should not be construed to mean insulation from other types of capital gains distributions.

"I'm not saying that no iShare holders suffer capital gains. I'm saying that no iShare holders suffer capital gains engendered because others decide to leave a fund. iShare holders can experience capitals gains for other reasons. iShares are constructed in the same way a mutual fund is. An ETF must make capital gains distributions in the event of an index reconstitution of the fund, or when a rebalancing takes place. And these capital gains will be distributed to fund participants."

The unique benefits Zigler discusses occur because ETFs can get rid of their lower cost basis stocks during the redemption process, thereby leaving the fund with less imbedded capital gains. Thus, when a fund rebalances after an index change, the gains on the shares that were sold can be less than those paid by traditional funds that use HIFO accounting, and therefore tend to hold lower cost basis stocks and higher imbedded gains.

When Taxes Are Priority One

"For the very tax conscious," says Mattes, "where tax considerations are a priority, Vanguard offers of number of funds that never realize capital gains. They do this by crossing losses against gains to neutralize tax impact. These funds are for long-term investors and contain several incentives to reduce trading activity. There is a two percent redemption penalty for redeeming assets in the first year, and a one percent penalty in each of the next four years should investors opt out of these funds." This, of course, lowers turnover, and therefore the tax exposure suffered by the fund.