In my last post, I talked about how some investors use fixed income exchange traded funds (ETFs) as an investment bridge – a place to put money when moving between managers or making other portfolio changes. Two of the main reasons we see ETFs used in this way are index tracking and liquidity. But there’s another big factor, one that’s especially relevant this time of year: taxes. I talked to one of our experts, BlackRock Managing Director Rob Nestor*, about why taxes are a major consideration when making a move. Q: Rob, I’ve heard you speak to the “total cost of ownership” when it comes to investing. Most people think of buying a car when they hear this phrase, so how does it apply to a portfolio?

A: When you’re shopping for a car you don’t just look at the sticker price, you also have to consider the maintenance fees, insurance and gas mileage. When looking for the right investment, the same principle applies: you need to look all the costs of ownership. This includes not only the management fees but also the costs to buy and sell the fund, and the fund’s tax efficiency. Only by looking at the whole picture can you get a sense of what you’re really paying.

Q: Let’s focus on the tax efficiency part. First, what does tax efficiency actually mean? Is it specific to a particular type of investment?

A: All mutual funds and ETFs are susceptible to making an annual distribution ofcapital gains. When a fund buys and sells securities during the year, it realizes a capital gain or loss on each transaction. At the end of the year, the impact of these transactions is added up to determine whether the fund generated realized net capital gains or losses. If the fund is in a net realized gain position, then fund investors will need to pay taxes on the gain in the year it was received, assuming it is held in a taxable account. (If held in an IRA for instance, then the distribution isn’t a concern.)

Q: Let’s explore that a little more. As an investor, you want your portfolio to do well, and “gains” tend to be a good thing. So why are capital gains distributions generally frowned on by most investors?

A: Four reasons. First, capital gains essentially return your money to you early. You get cash when you probably wanted to stay invested. Even though most accounts provide for automatic reinvestment, you have to pay the tax on a distribution whether you reinvest or not. Second, the gain could be classified as short term or long term; it depends on how long your fund held the security that triggered the gain. (For most investors, a short-term gain is taxed at a considerably higher rate than a long-term gain.) Third, the gain is driven by the actions of the portfolio manager, not you, and not directly by the performance of your investment. This means it’s possible to buy a fund, have it fall in value, and get a capital gain tax bill on top of the loss of investment value. Fourth, and probably most importantly, these distributions accelerate the payment of taxes that otherwise wouldn’t occur until a later date (if at all). Generally, although there are some exceptions (such as increases in future tax rates), accelerating tax payments results in real opportunity cost loss.

Q: Let’s look at ETFs specifically. We’ve discussed on The Blog before about how they are generally designed to be tax efficient. When an investor is thinking about using an ETF, what do they need to know about capital gains?

A: Generally an investor shouldn’t let taxes, or any other cost, “wag the investment dog”. Getting the asset exposure right generally has more to do with driving your long-term investment experience than any other factor. That said, it’s important to understand that ETFs tend to be fairly tax efficient because of the way they’re structured. Because they’re index funds, they have limited turnover and thus tend to have fewer transactions that could generate capital gains than mutual funds. Plus, the majority of money coming out of ETFs does so in the form of a transfer of securities, which is more tax efficient then if the fund had to sell securities. When capital gains distributions are paid, they are given to all fund holders, regardless of when those holders purchased the fund.

Of course ETFs can at times make capital gains distributions; they just tend to make distributions less frequently (and generally smaller) than mutual funds. In 2013, 6% of the iShares fixed income ETFs paid a capital gains distribution, versus 44% for mutual funds1. It’s impossible to predict exactly how efficient ETFs will be in 2014, but, the ETF is likely to offer fewer tax surprises.

1 Source: Morningstar, as of 12/31/2013. Includes the oldest share class of all Taxable and Tax Preferred (excludes Money Market and Convertible) Open End Fixed Income Mutual Funds and iShares ETFs available in the U.S. that incepted on or before 10/31/2013. Past distributions are not indicative of future distributions. *Rob Nestor is the head of iShares Retail Product Strategy at BlackRock and has extensive experience in ETF product development and portfolio construction.

Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. 

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders. Certain traditional mutual funds can also be tax efficient.

This material is provided for educational purposes only and does not constitute investment advice. The information contained herein is based on current tax laws, which may change in the future. BlackRock cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. The information provided in this material does not constitute any specific legal, tax or accounting advice. Please consult with qualified professionals for this type of advice. Investment comparisons are for illustrative purposes only. To better understand the similarities and differences between investments, including investment objectives, risks, fees and expenses, it is important to read the products’ prospectuses.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”). ©2014 BlackRock. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners. iS-13766-1014

iS-13766

Click here to read the original article on ETFdb.com.