By Nathan Sonnenberg
NEW YORK (AdviceIQ) — After tax season, when they realize exactly how much they paid at home, a number of my friends, colleagues and clients asked me what they should do to reduce their burden next year. While I'm not a tax professional, I certainly pay attention to tax rules and rates regarding investing.
My short answer to their question was: Create a portfolio of low-fee, thoughtfully constructed stock index mutual funds or exchange-traded funds. Yet not all of them do the job for you. Here's how to find the right one.
An index mutual fund is a passively managed fund that tracks the performance of a certain index, such as the Dow Jones Industrial Average, or a broad bond or commodity index. An ETF is similar to an index mutual fund, but is traded on the stock exchanges, like a stock. Rather than buying all of the stocks in the Dow Jones or Standard & Poor's 500, you can simply own an ETF that tracks that index.
Because index mutual funds or ETFs are not actively managed, their fees are often low. Also, their low turnover — how frequently stocks are bought and sold within a portfolio — provides tax benefits as excess activity creates the potential for more taxable events.Read More: Relying on the Stock Market? Nothing Goes Up Forever Consider these three aspects before buying an index fund or ETF: 1. Market exposure. Decide what you want to own. This is obvious, but not simple. Choosing from the broad number of stock index providers can be overwhelming (the Dow, S&P 500, Russell 2000, MSCI, FTSE). Therefore, it's important to understand what markets, countries, regions, industries, sectors and stocks the index fund you buy contains. Is your goal to own large stocks, small stocks or both? Do you want U.S. stocks, international, emerging-market or all of the above? Just as important, the fund you choose should adhere closely to its benchmark index. The more closely the investment matches that of the desired exposure, the better. Websites such as ETF.com and Morningstar.com provide great resources. 2. Fees. Like actively managed mutual funds, every index fund and ETF have management fees. These range from more than 1% to as low as 0.04% per year. The lower your investment fees, the more of the returns you keep. Another factor affecting cost is liquidity or, put simply, how easy it is to buy and sell the investment. With mutual funds, this is not an issue because they are bought or sold at the end of each day. For ETFs, which are traded like stocks, their liquidity is a more important issue. If an ETF is thinly traded, to buy or sell it may be more costly. 3. Tax cost ratios. This measures how much the taxes you pay on distributions reduce a fund's return. The lower this number, the better. Morningstar, an industry leader in tracking investments, offers this information for free. Now that you know what you should keep in mind before investing in index mutual funds or ETFs, here are four investments in different markets for your consideration: Broad U.S. stock market: Schwab U.S. Broad Market
Portfolio: Diversified exposure across 2,000 large and small-capitalization U.S. stocks
Current yield: 1.75%
Expense ratio: 0.04%. Three-year tax cost ratio: 0.76 S&P 500: Vanguard S&P 500 Index Fund
Portfolio: Seeks to track the performance of the S&P 500 stock index.
Current yield: 1.68%
Expense ratio: 0.17%. Three-year tax cost ratio: 0.49 International stocks: Vanguard Total International Stock
Portfolio: Seeks to track the performance of a broad, international index made up of approximately 5,500 stocks (83% in developed countries, 17% in emerging countries).
Current yield: 3%
Expense ratio: 0.22%. Three-year tax cost ratio: 1.01 Read More: How to Invest in Tech When Stocks Keep Disappointing Emerging market stocks: iShares Emerging Markets
Portfolio: Seeks to track the performance of the MSCI Emerging Markets index, made up of of more than 800 stocks in 16 countries.
Current yield: 1.57%
Expense ratio: 0.67%. Three-year tax cost ratio: 0.46 If you want broad stock market exposure in your portfolio, consider these. They are very effective at accomplishing the dual objectives of high tax efficiency and low cost. Follow AdviceIQ on Twitter at @adviceiq. Nathan Sonnenberg is chief investment officer of Glassman Wealth Services, a fee-only investment management, financial planning and wealth management firm in McLean, Va. His experience includes the unique perspective of having directed the outsourced research efforts for more than 90 high-net worth wealth management firms and wealthy families, in addition to managing the investment research, portfolio construction and development of asset allocation strategies for clients. AdviceIQ delivers quality personal finance articles by financial advisers and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.