Exchange-traded funds increasingly find a place in investor portfolios.
According to Charles Schwab’s 2017 ETF Investor Study, 42 percent of investors primarily invest in ETFs, up from 30 percent in 2015. Forty-five percent of investors plan to increase their ETF holdings in the next year. That figure shoots up to 60 percent for millennial investors.
ETFs have multiple draws. A 2017 BlackRock ETF Pulse Survey found that low management fees, low trading costs and simplified diversification ranked as the top three ETF features for individual investors. Financial advisors also cited low management fees, along with tax efficiency and the range of investment choices, as reasons to favor ETFs.
[See: The 10 Best ETFs to Buy for 2018.]
Performance is another attraction. According to Morningstar data, the top 20 ETFs generated a year-to-date return of 9.35 percent or higher through the early trading days of January. The best-performing ETF, the UBS ETRACS CMCI Industrial Metals Total Return ETN ( UBM), yielded a year-to-date return of 32.12.
Now that the GOP-led Congress passed its package of tax cuts, a big question for ETF investors is how tax reform may affect investments. Jay Hatfield, president and co-founder of New York-based InfraCap and portfolio manager of InfraCap MLP ETF ( AMZA), says the new tax bill will be positive overall for corporations and the economy, “resulting in another strong year for stock prices.”
The Dow Jones industrial average’s recent surge past 25,000 could be viewed as proof positive that tax reform is bolstering an already strong bull market. But some ETF sectors may fare better than others as new tax changes take effect.
Who should come out ahead? A focal point of the tax reform bill is corporate tax cuts. Corporations will pay a flat 21 percent tax rate on profits, down significantly from the previous 35 percent. The move is designed in part to make U.S. businesses more competitive overseas, where the average corporate tax rate hovers around 25 percent.
The reduced tax rate will have a marked effect on a corporation’s ability to deploy cash, says Art Amador, COO and co-founder of San Francisco-based EquBot, which developed the AI Powered Equity ETF ( AIEQ) using IBM’s Watson artificial intelligence. “Companies can use excess cash to benefit investors through share repurchases or dividends, or invest the money into their organization in the form of capital expenditures or additional hiring.” If corporations are returning cash to shareholders directly or investing in capital expenditures that improve operating outcomes, that could be a boon for stock investors in general.
From an ETF perspective, Michael Neuenschwander, a certified financial planner and certified public accountant at Outlook Wealth Advisors in Houston, says sectors that have large amounts of cash to repatriate — including automotive, tech and pharmaceuticals — should do well under the new tax law.
ETF investors may also want to keep an eye on domestic companies and sectors that paid the highest taxes under the previous tax code, including retail, restaurants, transportation and telecommunications. “Huge multinational corporations probably stand to benefit a little less than smaller companies with [fewer] international sales, since they’ve been able to take advantage of lower international tax rates,” says Matt Hylland, registered investment advisor and founder of Hylland Capital Management in North Liberty, Iowa. For example, in its most recent quarterly report, Coca-Cola Co. ( KO) estimated an effective tax rate of 24 percent for 2017. BB&T Corp. ( BBT), a regional bank that does business primarily in the U.S., paid an effective tax rate of 31.2 percent by comparison.
Tax reform’s potential losers are a mixed bag. While some ETF sectors should get a boost from tax reform, others may feel a limited or negative impact.
Matthew Essmann, managing partner at Cornerstone Financial Services in Birmingham, Michigan, says companies in sectors that traditionally weren’t paying taxes close to the full corporate rate will benefit less than those that were. That includes real estate, utilities, technology, materials and health care. This doesn’t mean they’ll necessarily take a hit, however, “because they could still perform well due to their fundamentals.”
[See: 7 ETFs to Profit From Recent Tax Cuts.]
Neuenschwander says tax reform’s effects may be more enhanced in the real estate and health care sectors. He says the new cap on state and local tax deductions for property taxes and the reduction of the mortgage interest deduction may soften the housing market, with homebuilding ETFs suffering as a result. Conversely, “the general real estate sector, which is more focused on commercial property, may benefit from the lower corporate tax rate, so the lesson here is to understand what your ETFs actually own.”
Health care ETFs could be a mixed bag. The removal of the health insurance mandate could push premium and health care costs higher. If more Americans go uninsured, as the Congressional Budget Office predicts, profit margins for health care providers and insurers could shrink. On the other hand, the tax cuts could benefit those same companies. According to Credit Suisse, the health care industry is one of the most taxed, with an effective tax rate of 30.2 percent. Tax reform could lead to higher earnings for private health care and insurance providers.
Bond ETFs are another question mark. Hatfield says the forecast is for long-term interest rates to remain low because the demand from pension funds keeps rates down. Consequently, “bond ETFs should be able to at least produce a return in line with their stated yield.”
Hylland says bond ETF investors should watch whether the tax bill results in corporations issuing fewer bonds, as not all bond interest will be deductible. The tax reform plan stipulates that interest expenses over 30 percent of earnings before interest, taxes, depreciation and amortization will not be deductible. “We could see a rise in preferred shares being issued instead of bonds, or companies may favor stock issuance instead.”
Watch and wait. Until the full effects of tax reform are known, ETF investors should avoid straying off-course. “Investors should do what they always do in the beginning of the year and rebalance their portfolio,” he says. Next, they should make sure they’re well-diversified across sectors and determine if any tactical moves should be made with their sub-sector allocations. “Possibly taking some gains off the table from the previous year’s winners and adding exposure in telecom, financials and industrials are the types of strategic moves that could prove to beneficial this year.”
[See: 10 Investing Themes to Remember for 2018.]
The one thing investors shouldn’t do is make major shifts with their investments right now, Essmann says. “Small changes and a balanced, diversified portfolio should lead to a strong 2018.”
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Why ETF Investors Should Care About Tax Reform originally appeared on usnews.com
