Subscriber Q&A: Tax Efficient Funds

April 15, 2014

taxSubscriber Question:

Is there a way to know if a fund or an ETF is tax efficient?

NoLoad FundX Answer:

We believe that the best predictor of after-tax return is pre-tax return – and that’s what we show in NoLoad FundX.

We don’t know of any way to determine, in advance, how tax efficient a fund will be. Some people believe that funds with lower turnover will be tax efficient because funds that don’t trade as much during the year won’t realize as many capital gains. But low-turnover funds do not capture tax losses as they occur and, more importantly, they may have large, embedded (unrealized) gains. When the portfolio managers are prompted to sell off their long-term holdings, they will have to realize those large capital gains.  They may not look so tax efficient then. We saw this in 2008 when any shareholders redeemed their mutual fund shares in the face of a fast-declining market. In order to accommodate these liquidations, many low-turnover funds were forced to sell shares of their long-term holdings, thus realizing larger taxable gains. Funds with higher portfolio turnover can often meet shareholder redemptions by realizing smaller gains or even losses (which can then be used to offset future gains).

With Upgrading, we tend to realize capital gains (and losses) as we change our portfolios over time, and while this active strategy may not look tax efficient, as we showed in the April issue, it has ultimately outperformed a low-turnover index fund before- and after-taxes. (A previous study of before- and after-tax returns is available here).

More effective than any generalized tax-efficiency “score” is to be aware of the tax effect a fund has on your own individual portfolio. That depends on how long you own it, how much it gains or loses during the time you own it, and what distributions it makes while you own it.  If a fund pays out a big taxable gain, but you sell the fund before the gain is distributed, then your personal impact is nil.  Knowing how much a fund has paid out in the past or how much unrealized gain it now holds is less important than knowing how much a fund is about to pay out next week.

We provide guidance every tax season in the form of estimated payout amounts and distribution dates so subscribers can take action in their own accounts.  In our model portfolios, we also remind investors to consider holding for an extra month or two if a position may be approaching the 12-month holding period, so the gain will be treated as long-term. The information we provide in NoLoad FundX is a powerful tool for taking control of your portfolio and its tax efficiency.


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