Tag: tax efficiency

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Risks and Opportunities in Fixed-Income ETFs

Fixed-income ETFs (also known as bond ETFs) continue to grow at a rapid pace. Bond ETFs now exist across a wide spectrum of characteristics. Looking for shorter or longer maturity? Or, how about higher yield (aka junk bonds) versus investment grade or Treasury bonds? ETFs even cover the bond markets in both emerging and developed economies worldwide.

At this rate, State Street Global Advisers predicts that assets in bond ETFs could reach $1 trillion by the end of 2019.

What is driving demand?

Like stock-based ETFs, low cost is a big driver. Greater tax efficiency, as we discussed in detail in a post earlier this year, over bond mutual funds helps too. But, the biggest demand could be simply choice.

“Investors really have a lot of choices — more than they’ve had in the past five years. “

Noel Archard, State Street Global Advisors

Liquidity concerns?

Our opinion at ETFMathGuy is that liquidity concerns are minimal. In fact, real-time ETF price availability helps the price discovery process, and should improve liquidity.

“Fixed-income ETFs have been tested more than once over the past 10-11 years, without any major issues. “

Rich Powers, Vanguard

The current focus of fixed-income ETFs

The current focus of fixed-income ETFs is now in portfolio construction. Here at ETFMathGuy, we are helping to lead this initiative by building portfolios to take full advantage of what fixed-income ETFs have to offer. For instance, in the May taxable conservative portfolio for Vanguard, we show a portfolio with a a variety of fixed-income ETFs in it. We also seek to include higher volume alternative ETFs, to mitigate any possible liquidity issues and minimize the bid-ask spread trading costs.

May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy.
May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy

In conclusion, fixed-income ETFs are in important core component of an optimally diversified portfolio. We invite you to browse through the current month optimal portfolios to see the importance of bond ETFs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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ETF Tax Efficiency vs. Mutual Funds

Much has been written about ETF tax efficiency. In this blog post, we summarize what these tax advantages look like to a individual investor who may be considering mutual funds as an alternative.

Let’s start with the basics of capital gains taxes. Short term capital gains are taxed as ordinary income, which for individuals in higher tax brackets, is far from ideal. Below are the tax brackets for married filing jointly in 2018.

The 2018 tax brackets and rates for married couples filing jointly.
Source: CNBC.COM. About half of Americans don’t know what tax bracket they’re now in—here’s how to find out., by Kathleen Elkins

So, let’s suppose you and your spouse made $175,000 in 2018. Then, for every additional $1 of short-term capital gains, you owe 24 cents of income tax. If you are fortunate enough to be earning more, tax rates are even higher. For this reason, higher earners often use municipal bond ETFs in their taxable portfolios.

What produces short-term capital gains?

There are several ways that individual investors produce short-term capital gains with ETFs and mutual funds.

  • Buying an ETF or mutual fund and reselling it for a gain in less than a year.
  • Non-qualified dividends, often produced by fixed income mutual funds and ETFs.
  • Mutual funds that buy and sell assets in their fund to meet their stated objectives or to satisfy investor redemption*.

*This last point is where ETFs carry a significant advantage. The higher the turnover of a mutual fund’s assets, the more often short-term capital gains are passed on to the individual investor.

“If your fund distributes capital gains often, your tax bill may suffer.”

Source: “How Often Do Mutual Funds Pay Capital Gains?”, by
Claire Boyte-White, Investopedia.

But, ETFs have a creation/redemption process that shields these gains from the ETF investor. While some would say it’s a tax dodge, this process has represented a significant ETF tax efficiency for over 20 years. Below is a chart that shows how often these events occurred in comparable index ETFs and index mutual funds.

Examples of ETF tax efficiency, by generating fewer taxable gains than mutual funds.
Source: Bloomberg.

Conclusions

Tax efficiency is an important aspect that individual investors should consider. ETFs generally offer better tax efficiency than comparable mutual funds. While this efficiency is important for all investors, higher wage earners can reap the greatest tax benefits of using ETFs versus mutual funds.