At Financial Plan, we are analytical to a fault when evaluating investments.  We continually ask the question: “Are we populating our accounts with optimal securities, or are there other selections that are clearly better?”  We might define “better” as wholly subscribing to our investment philosophy while demonstrating improvement to the items we can control; including among other things costs and tax efficiency.

We ask ourselves that question every year, and in recent memory we have not been able to identify securities that were better than what we were already using.

This year was different.

The new “ETF Rule” passed down in 2019 by the S.E.C. makes custom creation and redemption baskets available for all Exchange Traded Funds (ETFs).  A “basket” is a collection of multiple stocks or other securities. After months of review, and considering this new rule, we have introduced equity ETFs to our taxable accounts, replacing our prior open-end mutual funds (when not precluded by adverse tax consequences.)  The result is lower costs and more tax efficiency.  Here is how it works:

Lower costs

In no-load pooled investments, clients incur costs primarily through expense ratios and trading costs.  The mutual funds we utilize have carried exceptionally low expense ratios, but they are reduced even further with the ETFs.  The trading costs are also reduced for long-term holders of the investment, because in ETFs, trading costs are incurred only once upon purchase and once upon sale. The ongoing trading that takes place due to the purchase and sale of ETF shares by other shareholders is external to the fund; borne only by the buyers and sellers, not by the existing ETF shareholders. Contrast that to an open-end fund, in which all shareholders pay the costs of all ongoing trading. Thanks to the new ETF rule allowing for custom baskets, the trading due to rebalancing within the ETF typically occurs outside of the fund.  An ETF that wishes to change the complexion of its portfolio can execute a “like kind” exchange with a market maker, delivering a basket of securities that is different but similar to the initial basket.  There are no trading costs for the exchange. The trading in the underlying securities necessary to create and redeem these baskets is accomplished by the market maker who, as a dealer in the securities, profits from the trades through the spread.

Tax Efficiency 

The ETFs are also more tax efficient than most open-end mutual funds.  Again, this is related to the new ETF Rule allowing for custom baskets.  When the ETF makes a “like kind” exchange of a basket of securities, the tax treatment is like others we are familiar with, including 1031 exchanges of real estate and 1035 exchanges of insurance products:  the tax is deferred.  Better yet, with ETFs, the ETF never incurs tax on appreciated securities within a basket that has been exchanged.  The ETF ends up with a new basket of securities, along with a new stepped up tax basis.

The result of this is that although the ETF will still make taxable dividends, it need not ever make taxable capital gains distributions.  An ETF can and will select securities with low tax basis and simply exchange them away thereby eliminating the unrealized capital gains.

It is important to note that the capital gains distributions that are avoided will be realized by the ETF shareholder upon sale.  Unless there is a step up in basis due to death, the advantage is tax deferral only. Considering that tax deferral is also the only tax benefit of a traditional retirement plan, we know there is still a huge tax benefit. Any tax dollar deferred is beneficial, whether a dollar of capital gains tax or ordinary income tax.

In summary, we believe that when comparing ETFs to open-end mutual funds, ETFs can be a less costly and more tax efficient way to access the capital markets in taxable accounts.  Keep in mind that ETFs need not be mindless indexers; they can utilize factors to capture higher expected returns, just as open-end funds can.  It is difficult to quantify the annual advantage of ETFs compared to open-end funds in taxable accounts due to cost and tax differences, but our rough estimate is in the range of 30 to 40 basis points for an investor in the top tax bracket. If that estimate is remotely close, the compounded effect is projected to be highly significant to long term investors.

Disclaimer

This article does not mention, recommend, or address past or expected investment performance of any specific open- end mutual fund or ETF, nor does it make any statement or comparison as to expected returns of open-end funds versus ETFs in general.  Not all ETFs utilize factors, and not all ETFs have lower expense ratios than similar open-end funds. The circumstances of individual investors vary, and they should be considered before any investment advice is implemented.

James Twining
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