Utilization of ETFs

CLS’s Tax Management strategies utilize ETFs, primarily due to their inherent tax efficient structure.

Any time a traditional mutual fund sells shares that have appreciated in value, it creates capital gains that must be paid out to shareholders by the end of the year. No matter why these sales occur – tactical moves, rebalancing, or, commonly, to meet shareholder redemptions – the ensuing capital gains distributions create a tax liability for all investors in the fund.

Tax managed mutual funds are available, but these funds have historically underperformed the market partly because their management is heavily restricted by tax considerations. Additionally, since tax efficiency is not inherent in a mutual fund, it may not be the best application of mutual funds’ active management approach.

Conversely, holding an ETF in a taxable account will generally result in fewer tax liabilities than holding a similarly structured mutual fund in the same account. First, this is due to the fact that most ETFs have very little turnover and therefore amass far fewer capital gains than an actively managed mutual fund. It is rare for an index-based ETF to pay out capital gains. Second, ETFs are more tax efficient due to their unique creation/redemption process. When mutual fund investors sell their shares, the fund must sell securities to raise cash to meet that redemption. However, an ETF investor can simply sell his or her ETF shares on an exchange like a stock, which means the ETF does not need to initiate an internal capital gains transaction. Additionally, unlike mutual funds, which typically sell securities to generate cash, most ETFs redeem securities “in-kind,” meaning they swap securities for securities, which doesn’t trigger a taxable event.

However, some ETFs are much more tax efficient than others. That’s why CLS’s professional tax management of investors’ ETF portfolios adds tremendous value. We analyze important metrics like portfolio turnover rate, tax cost ratio, and potential capital gain exposure to find ETFs for each portfolio that offer the best balance between tax efficiency and potential for growth.

How does the average tax cost of mutual funds and ETFs compare?
Graph was compiled using data from the Morningstar Direct Database. Morningstar provides figures for pre-tax and post-tax earnings for all ETFs and mutual funds domiciled in the US. With this information, a dollar-weighted average of tax expenses was calculated for both mutual funds and ETFs. The results are displayed in the graph. For information regarding how post-tax returns were calculated, refer to Morningstar directly.