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Can ETFs Help Reduce Taxes?

NEW YORK ( TheStreet -- With April 15 approaching, plenty of investors are faced with painful bills. The healthy markets of the past year produced ample taxable capital gains.

To limit the damage, many financial advisers recommend exchange-traded funds because of their tax efficiency. The praise may be warranted for big equity funds, which can help to control taxes over the long term. But in recent years, many ETFs have not been as tax efficient as comparable mutual funds.

Morningstar analyst Michael Rawson cautions tax-conscious investors to be particularly wary about bond ETFs. "In theory, bond ETFs should have a tax edge, but in practice we have not seen evidence of that," he says.

ETFs that invest in corporate and high-yield bonds tend to generate particularly steep tax bills. Consider iShares iBoxx High Yield (HYG), which invests in corporate bonds that are rated below-investment grade. During the past five years, the fund returned 8.77% annually. But after paying taxes, high-income investors would only keep 5.57%. According to Morningstar, the fund has a tax-cost ratio of 2.94, which represents approximately the size of the tax bite in percentage points.

Many actively managed high-yield mutual funds had lower tax bills. A top performer was Buffalo High Yield (BUFHX), which returned 9.20% before taxes and only had a tax cost ratio of 2.20. Pioneer High Yield (TAHYX) had a tax cost ratio of 0.96.

Many equity ETFs have also been less tax efficient than comparable mutual funds. During the past five years, SPDR S&P 500 (SPY), the biggest ETF, with $129 billion in assets, had a tax cost ratio of 0.54. In the same period, dozens of large blend actively managed mutual funds had lower bills. Among top-performing funds were Prudential Jennison Equity Opportunity (PJIAX), with a tax-cost ratio of 0.17, and Lord Abbett Fundamental Equity (LAVPX), with a figure of 0.21.

Will equity mutual funds remain more tax efficient than ETFs in the future? Not necessarily. But the recent performance should serve as a reminder that ETFs are not always the better choice.

If the current bull market continues, mutual funds could be less tax efficient because of some structural disadvantages. To appreciate the tax problem, consider what happens when an investor sells shares in a typical stock mutual fund. The investor requests a redemption from the fund, exchanging shares for cash. To raise cash, the fund portfolio manager may be forced to sell stocks. If the stocks had appreciated, the sales may generate taxable capital gains. The gains could result in bills for shareholders, including those who are not leaving the fund.
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