tax brackets.
In the world of ETFs, such losses are very unlikely to happen. Because most ETFs are index-based, they generally have little turnover to create capital gains. To boot, ETFs are structured in a way that largely insulates shareholders from capital gains that result when mutual funds are forced to sell in order to free up cash to pay off shareholders who cash in their chips.
No tax calories
The structure of ETFs makes them different from mutual funds. Actually, ETFs are legally structured in three different ways: as exchange-traded open-end mutual funds, exchange-traded unit investment trusts, and exchange-traded grantor trusts. The differences are subtle, and I elaborate on them somewhat in Chapter 3 and throughout Part II. For now, I want to focus on one seminal difference between ETFs and mutual funds, which boils down to an extremely clever setup whereby ETF shares, which represent stock holdings, can be traded without any actual trading of stocks. In a way it’s like fat-free potato chips (remember Olestra?), which have no fat calories because the fat just passes through your body.
Market makers and croupiers
In the world of ETFs, we don’t have croupiers, but we have market makers. Market makers are people who work at the stock exchanges and create (like magic!) ETF shares. Each ETF share represents a portion of a portfolio of stocks, sort of like poker chips represent a pile of cash. As an ETF grows, so does the number of shares. Concurrently (once a day), new stocks are added to a portfolio that mirrors the ETF.
When an ETF investor sells shares, those shares are bought by a market maker who turns around and sells them to another ETF investor. By contrast, with mutual funds, if one person sells, the mutual fund must sell off shares of the underlying stock to pay off the shareholder. If stocks sold in the mutual fund are being sold for more than the original purchase price, the shareholders left behind are stuck paying a capital gains tax. In some years, that amount can be substantial.
In the world of ETFs, no such thing has happened or is likely to happen, at least not with the vast majority of ETFs, which are index funds. Because index funds trade infrequently, and because of ETFs’ poker-chip structure, ETF investors rarely see a bill from Uncle Sam for any capital gains tax. That’s not a guarantee that there will never be capital gains on any index ETF, but if there ever are, they are sure to be minor.
The actively managed ETFs – currently a very small fraction of the ETF market, but almost certain to grow – may present a somewhat different story. They are going to be, no doubt, less tax friendly than index ETFs but more tax friendly than actively managed mutual funds. Exactly where will they fall on the spectrum? It may take another year or two (or three) before we really know.
ETFs that invest in taxable bonds and throw off taxable bond interest are not likely to be very much more tax friendly than taxable-bond mutual funds.
ETFs that invest in actual commodities, holding real silver or gold, tax you at the “collectible” rate of 28 percent. And ETFs that tap into derivatives (such as commodity futures) and currencies sometimes bring with them very complex (and costly) tax issues.
Taxes on earnings – be they dividends or interest or money made on currency swaps – aren’t an issue if your money is held in a tax-advantaged account, such as a Roth IRA.
A key to building a successful portfolio, right up there with low costs and tax efficiency, is diversification. You cannot diversify optimally unless you know exactly what’s in your portfolio. In a rather infamous example, when tech stocks (some more than others) started to go belly up in 2000, holders of Janus mutual funds got clobbered. That’s because they learned after the fact that their three or four Janus mutual funds, which gave the illusion of diversification, were actually holding many of the same stocks.
Style drift: An epidemic
One classic case of style drift cost investors in the all-popular Fidelity Magellan Fund bundle. The year was 1996, and then fund manager Jeffrey Vinik reduced the stock holdings in his “stock” mutual fund to 70 percent. He had 30 percent of the fund’s assets in bonds or short-term securities. He was betting that the market was going to sour, and he was planning to fully invest in stocks after it did. He was dead wrong. Instead, the market continued to soar, bonds took a dive, Fidelity Magellan seriously underperformed, and Vinik was out.
One study by the Association of Investment Management concluded that a full 40 percent of actively managed mutual funds are not what they say they are. Some funds bounce around in style so much that an investor would have almost no idea where her money was.
ETFs are the cure
When you buy an indexed ETF, you get complete transparency. You know exactly what you are buying. No matter what the ETF, you can see in the prospectus or on the ETF provider’s website (or on any number of independent financial websites) a complete picture of the ETF’s holdings. See, for example, http://finance.yahoo.com. If I go and type the letters IYE (the ticker symbol for the iShares Dow Jones U.S Energy Sector ETF) in the box on the top of the page, and then click the Holdings link on the left, I can see in an instant what my holdings are.
You simply can’t get that information on most actively managed mutual funds. Or if you can, the information is both stale and subject to change without notice.
Transparency also discourages dishonesty
The scandals that have rocked the mutual fund world over the years have left the world of ETFs untouched. There’s not a whole lot of manipulation that a fund manager can do when his picks are tied to an index. And because ETFs trade throughout the day, with the price flashing across thousands of computer screens worldwide, there is no room to take advantage of the “stale” pricing that occurs after the markets close and mutual fund orders are settled. All in all, ETF investors are much less likely ever to get bamboozled than are investors in active mutual funds.
Getting the Professional Edge
I don’t know about you, but when I take the kids bowling and – as happens on very rare occasion – I bowl a strike, I feel as if a miracle of biblical proportions has occurred. And then I turn on the television, stumble upon a professional bowling tournament, and see guys for whom not bowling a strike is a rare occurrence. The difference between amateur and professional bowlers is huge. The difference between investment amateurs and investment professionals can be just as huge. But you can close much
