Considering how tax efficient your investments are is a big deal. Building a more tax efficient portfolio can improve your chances of keeping more money in your account for your longer-term needs. So, finding strategies to manage for taxes is nearly as important as portfolio returns for many. But, did you know that the type of investment vehicle you choose can have a big impact on tax efficiency?
Let’s compare the mutual fund vs. the exchange traded fund (ETF)…
Think of the stocks, bonds or commodities as a flavor of ice cream–let’s say chocolate or a favorite…mint chocolate chip. Your server asks you how you’d like to receive your mint chocolate chip, in a cup or cone? Consider a mutual fund as the cup and an exchange traded fund (ETF) as the cone. And, as mentioned, the stocks or bonds are the ice cream. So, your choice of container can give you an assist with building a more tax-efficient portfolio. Here’s how and why…
These two “investment holders” are similar, yet it’s important to know the striking differences like transparency, tax efficiency and control.
The transparency of your investment is an important consideration for a more tax efficient portfolio. The ETF provides more transparency than the mutual fund. With an ETF, most ETF sponsors are required to and/or do report the underlying holdings on a daily basis. In contrast, a mutual fund is required to report its holdings much less frequently–on a quarterly basis. Transparency can become even more important during a market sell-off. In addition to tax efficiency, knowing what you own can be critical. Transparency during a market downturn is an important part of diversification and risk management.
With most ETFs, if you own it and decide to sell it, your gain or loss will be based on your original cost basis (similar to a stock). But, as the investor in a mutual fund, you may have taxes to pay regardless of whether or not you sell the fund. Here’s how…If the manager of the mutual fund sells assets within the mutual fund during the year, the investor may have a tax consequence. Capital gains realized by the fund get transferred or paid out to the investor. While gains can be a good thing, sometimes, even though the mutual fund itself may be down in value, you still may have taxes to pay. And those gains are typically paid at year-end when there’s less time to manage for their tax impact.
An ETF trades like a stock, meaning it will have a bid and offer throughout the trading day. A mutual fund, in contrast, prices at its net asset value (NAV) on a daily basis. This means that buyers and sellers will get the price of the fund as of its value at the end of the trading day, not intra-day as with an ETF. Therefore, you have more control over the price you’ll take when you sell an ETF vs. a Mutual Fund.
And, there’s another thing to consider and it’s the cost differences between a mutual fund and an ETF. Fidelity writes,”For the most part, ETFs are less costly than mutual funds. There are exceptions—and investors should always examine the relative costs of ETFs and mutual funds that track the same indexes. However—all else being equal—the structural differences between the 2 products do give ETFs a cost advantage over mutual funds.”
As experienced advisors, we believe it important to look at the size, style, sector, risk, etc. (the “flavor,” if you will) of an investment. And, importantly also the “cone” in helping clients decide on the most appropriate investment choices for them. Remember, your investment vehicle choices can become an important part of building a more tax efficient portfolio.
The views expressed in this post are as of the date of the posting and are subject to change based on market and other conditions. This post contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance. Actual results or developments may differ materially from those projected.
Nothing in this post should be construed as an offer to sell, nor the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and should not be taken to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Lenity Financial, Inc. unless a client service agreement is in place.