Tax Efficiencies of ETFs of ETFs
In-Kind Transfer Process
When ETFs are traded, the unique in-kind transfer process used to create new shares or to redeem existing shares contributes significantly to their tax efficiency. When an investor purchases a mutual fund, they purchase its history. For example, if the mutual fund includes a stock that was purchased ten years ago and appreciated significantly since then, a recent purchaser of the mutual fund may still be liable for the capital gains when that stock is sold. With ETFs, the investor purchases the underlying stocks, which not only increases the transparency, but protects the investor from historical capital gains. More importantly, ETFs trade in-kind, meaning that the managers trade shares of the underlying securities for the ETF shares instead of cash. As they aren't selling the securities, there are no taxable distributions for these trades. For ETFs of ETFs, in-kind transfers eliminate any tax consequences from index rebalancing; it does not matter what the gains were on the components of the index. In a typical mutual fund, the tax consequences of index rebalancing average 90-100 basis points, so this is a very important distinction.
In addition to this direct protection from taxes, in-kind transfers ensure that taxes do not prevent ETF managers from rebalancing thanks to taxes. When rebalancing is necessary, ETF portfolios are much less susceptible to the tax effects that mutual funds must manage. When an asset class appreciates significantly and becomes a much larger risk component in their asset allocation strategy, many mutual funds are deterred by the tax effects of the trades that must be made in order to restore the target allocation. Thus, a fund may choose not to rebalance due to the tax effects of the necessary trades. New Frontier strategies implemented in an ETF of ETFs never encounter this problem due to the in-kind transfer process.
Institutional Asset Allocation with the Purchase of a Single Security
The ETFs based on New Frontier indices deliver New Frontier's institutional asset allocation strategies to investors with the purchase of just one security. Accessing any other well diversified asset allocation strategy via any other investment vehicle such as a mutual fund involves bearing the cost burden of multiple transactions for multiple securities, repeated every time the portfolio is rebalanced. In an ETF of ETFs, this rebalance occurs automatically within the ETF, so the investor does not have to be concerned with additional, repetitive trading. This can significantly affect the tax impact on a portfolio, since the investor does not have to be burdened with possible taxes on each individual trade.
Capital Gains
Capital gains distributions and accompanying taxes can impact investors either via the underlying funds in a fund, or when the portfolio itself is rebalanced. In mutual funds, capital gains are a somewhat necessary evil--if a mutual fund sells shares that have appreciated in value, all the investors in the fund bear the burden of capital gains distributions, whether or not they benefitted directly from the sale. In 2007, 51% of all equity mutual funds made capital gains distributions that totaled 3.3% of fund assets. Despite the market tumult of 2008 which resulted in many portfolios losing almost half their value, many investors suffered tax losses due to redemptions induced capital gains.
While there may be capital gain taxes to be paid on the profitable sale of an ETF as well, there is a significant difference. The capital gains tax on an asset in an ETF is only paid when the entire ETF is sold, not while you are holding the ETF, or a component is traded. A further advantage ensues from this ability to defer taxes until the entire ETF is liquidated, increasing the investor's time value of money.
HIFO v. LIFO Accounting
Another tax benefit of ETF portfolios is a result of the accounting method used in the purchase and redemption of securities. HIFO, or Highest In First Out, refers to the accounting method used by mutual funds, where the highest cost basis security is the first to be sold, increasing fund investors' capital gain exposure. LIFO, or Lowest In First Out, refers to a method of accounting used by ETFs where the lowest cost basis security is the first to be sold, decreasing capital gains exposure and presenting a more accurate picture of the current value of a security within the portfolio. When a component of an ETF portfolio needs to be sold, the lowest cost basis securities are the first to be liquidated. This results in lower realized appreciation, and thus lower taxes. Inversely, mutual funds are required to sell of the highest cost basis securities first, consequently increasing the tax burden for investors and further eroding performance value.
In a depreciating market, a manager may choose to sell the highest-cost basis securities in order to realize capital losses, which may help offset future capital-gain exposure. ETFs, and consequently ETFs of ETFs, offer the unique flexibility of being highly malleable tax-management strategies, both in up and down markets.
The core ETFs based on indices constructed by New Frontier use the LIFO (Lowest In, First Out) method of accounting, to help minimize and in some cases, eliminate capital gains distributions. This method allows for the removal of the lowest cost basis component securities via in-kind, non-taxable transfers. Thus, the ETF retains only the highest cost basis securities.
Traditional mutual funds on the other hand, use the HIFO, or Highest In First Out method to manage portfolios. This results in unrealized capital gains, which are distributed annually to investors in the portfolio, whether or not they profited from or suffered losses in the fund.
