Among the reasons to invest in index-style mutual funds and exchange-traded funds: they’re typically more “tax efficient” than actively managed funds. In other words, annual taxes are smaller.
But not all index products are as efficient as others, and occasionally investors are blindsided by big tax bills. Once you decide index products are for you it will pay to keep an eye out for ones likely to deliver an ugly surprise, which can come in an outsized year-end distribution this time of year.
“JP Morgan Equity Index fund (ticker: OGEAX), an S&P 500 index tracker, is estimating a 9 percent capital gains distribution in 2016, following on the heels of an even larger distribution in 2015,” Morningstar’s Christine Benz writes on her firm’s site in a recent post illustrating the problem of large index-product distributions.
[See: 10 ETFs That Pay Sky-High Dividends.]
Meanwhile, Vanguard Group’s Vanguard 500 Index Fund Investor Shares ( VFINX) is likely to pay nothing or next to nothing while tracking the same index.
Federal law requires funds to pay out net capital gains on holdings that were sold during the year, and those distributions are usually made in December. They are subject to long-or short-term capital gains tax unless the fund is held in a tax-favored account like an individual retirement account or 401(k). The big payout by OGEAX will equal about 9 percent of the fund’s share price, or $9 for every $100 invested.
Income oriented index funds like bond funds, real estate investment trusts and high dividend payers often cause unwelcome tax bills as well, though income typically comes throughout the year and not in a big year-end distribution, Benz notes.
“Investors focused on maintaining peak tax efficiency should steer their dividend-focused funds to their tax-sheltered accounts (like IRAs and 401(k)s) and stick with plain-vanilla broad-market index funds or ETFs for their taxable accounts,” she says.
Many actively managed funds have a habit of making large distributions because they do a lot of buying and selling in the hunt for hot holdings.
But index products avoid big distributions because they simply hold assets in the underlying index for the long term. If a stock the fund owns goes up, that adds to the fund’s share price, or net asset value, and the investor benefits when fund shares are redeemed for a higher price. While tax on those gains will be due at that point, the sale may be postponed for decades, with the tax savings helping to boost compounding in the meantime.
So what’s the deal with indexers that make large distributions?
In most cases these are due to selling of fund holdings to raise money to pay investors who are redeeming shares, says Richard Spurgin, associate professor of finance at Clark University’s Graduate School of Management in Worcester, Massachusetts.
That’s what’s happened to OGEAX. And the big redemptions have probably come, Benz says, because of the fund’s relatively high 0.45 percent expense ratio, more than four times the charges of some other funds tracking the Standard & Poor’s 500 index. Also, OGEAX has a hefty 5.45 percent load, or sales charge, to pay advisors and brokers who steer clients into the fund. Advisors are under a lot of pressure these days to put clients’ interests first, so they and their customers are opting out of high-fee funds.
[See: The 10 Best REIT ETFs on the Market.]
As mentioned, low turnover causes index funds to keep distributions small. But that can be achieved only if the underlying index has low turnover. The popularity of indexing has led to use of ever-smaller subsets of the broad market.
“If you are an index manager and provider of the commercial benchmarks tells you X number of stocks are being added to the index and X number of stocks are going to be deleted from the index, you have to buy and sell those stocks, thus causing capital gains (distributions),” says Robert J. Pyle, a planner with Diversified Asset Management in Boulder, Colorado.
“It is more prominent in smaller-cap indexes like the Russell 2000,” he adds, noting that index has over time managed to reduce turnover to about 12 percent a year from nearly 30 percent from 1996 to 2005. The S&P 500 turns over about 4 percent of its holdings in an average year, Benz says.
Index funds that track bonds, especially short-term bonds, can have high turnover because they must replace bonds that have matured or have aged to the point their maturities are too short. The more picky the index’s criteria for membership, the more likely it will frequently have to replace holdings that no longer fit.
Exchange-traded funds tend to be very tax efficient because they do not have to sell holdings to raise money to meet redemptions. Investors who want out just sell their shares on the stock market, as they would with ordinary stocks. Also, as part of the inner workings of ETFs, big investors called “authorized participants” can be paid off in securities rather than cash if they want out. Their participation allows the ETF to create or retire shares as demand changes.
Here’s what can you do to avoid funds that can trigger unexpectedly large taxes:
— First, look for an ETF alternative to your old-fashioned indexed mutual fund. Steer clear of index funds that in the past have paid bigger distributions than competitors have. Something about their way of doing things could make that happen again.
— Scour the prospectus and other fund materials for comments on tax efficiency. Some index managers make an extra effort to minimize distributions with techniques like selling the high-cost shares when they must cut back on a holding.
— Be wary of funds with higher expense ratios than other indexers in their category. High fees could spur redemptions.
— Look out for funds and ETFs that get too fancy by adding features such as leverage or betting on derivatives. Techniques meant to supercharge returns beyond those of the underlying index can spur big distributions or incur lots of redemptions if things go wrong.
[See: 7 of the Best ETFs to Own in 2017.]
Finally — and this may be blasphemy to index-investing believers — consider an actively managed fund designed to minimize distributions and taxes. These “tax managed” funds use all the tricks, such as selling losers to offset gains on winners, postponing sales to get the lower long-term capital gains rate, and selling the high-cost portions of a holding that will trigger the smallest taxable gain.
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Index Funds Can Pack a Tax Punch originally appeared on usnews.com
