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.

Now suppose an investor sells a stock ETF. To complete the transaction, the investor sells the shares on an exchange the way any stock is traded. If the investor recorded a gain, then the sale could produce a tax bill for him. But there would be no tax impact on the ETF portfolio. So investors who continue to own the ETF would not face bills.

The tax bills of many ETFs can be especially low because of the way that new shares are created and redeemed by institutions. Say an institution wants to redeem a large position in a fund that invests in the S&P 500. To accomplish the trade, the institution returns shares to the ETF. But the ETF portfolio manager does not pay in cash. Instead, the manager makes an in-kind exchange, providing actual shares of the 500 S&P stocks that are held by the fund. Because the fund does not sell any shares, there are no capital gains taxes.

In a bull market, the lack of capital gains can provide a significant edge for stock ETFs. But during the downturn of 2008, mutual funds had a tax advantage. In the turmoil of the financial crisis, many shareholders redeemed mutual fund shares. The funds were forced to sell stock at losses in order to raise cash. Those losses have stayed on the books and helped to offset capital gains. In contrast, the ETFs did not book many losses because of in-kind redemptions. As a result, many mutual funds have been more tax efficient than ETFs. Now that most of the tax losses have been used, the advantage of mutual funds could disappear.

Although stock ETFs can have a big tax advantage in bull markets, bond ETFs only enjoy a slight edge in good times. The advantage is limited because bond ETFs sometimes make redemptions in cash. To raise the cash, portfolio managers may have to sell bonds and record capital gains. Even if they make in-kind redemptions, bond ETFs have only a small edge over mutual funds because the fixed-income markets rarely produce big capital gains. If bonds record capital losses in coming years, as some economists expect, then mutual funds could enjoy a big tax advantage.

Should you avoid bond ETFs? Not necessarily. But you should shop carefully to find the ETFs and mutual funds that have demonstrated an ability to provide the most efficient solutions.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.