One of your goals for November should be to sell any mutual funds held in a taxable account and reinvest the proceeds into ETFs.

As we explained in “Would You Like Taxes with That?”, the large volume of recent redemptions on the part of mutual fund investors will likely stick loyal investors with a capital gains distribution tax bill in December – even if the fund is down 30 or 40% on the year.

The move out of mutual funds is not just a smart move for this year.  Shifting to ETFs will continue to pay off down the road due to lower overhead and better tax efficiency.  The “active management” of mutual funds is overrated – as we’ve noted elsewhere, investors waste $100 billion every year trying to beat the market.  Much of that money goes to the high fees and expenses of active managers who most likely will continue to underperform as 90% of them have through Q3.

With a weakening economy and the election cycle drawing to a close, the one thing we can count on is higher taxes.  State and local governments are scrambling to find ways to cover the shortfalls caused by higher unemployment and lower sales tax revenue. The federal government has already churned through hundreds of billions in rebate checks and bailout funds and will likely want to spend money at even a faster rate as part of the November 4 mandate.

Who is going to foot the bill?  As Fortune magazine puts it, “You Will”.

In a recent report, Barclays iShares concludes that we don’t know exactly what tax changes are coming, but we can be pretty sure that the “Bush” tax cuts on income, dividends and capital gains will expire in 2010.  If nothing else changes, the rates will adjust as shown in the accompanying table.

 

tax_code_expirations_110408

(click to expand)

Given the uncertain outlook for investments and the certainty of higher taxes, what should investors do?

The iShares report recommends starting with 2 questions:

1) Is my asset allocation tax efficient? and

2) Am I using tax-efficient vehicles?

Not surprisingly, iShares suggests starting your allocation evaluation by looking to see if you hold any mutual funds.  The creation/redemption structure of mutual funds results in regular capital gains distributions that put a drag on long-term returns.

According to a study by Lipper’s Tom Roseen, the long-term average tax “cost” for mutual fund taxable investors (both equity and fixed income) over the last ten years was between 1.3% and 2.2%.

ETFs are more tax efficient than actively managed mutual funds for a couple of reasons.

Lower portfolio turnover

As index funds, which track a benchmark of a particular asset class, ETFs (and traditional index mutual funds) tend to have lower portfolio turnover than actively managed funds, which translates into potentially lower capital gain distributions —and more tax efficiency.

 

Protection from shareholder activity

In contrast to a traditional mutual fund, ETF investors buy and sell shares on an exchange, a transaction that does not affect other shareholders and therefore doesn’t trigger capital gains for anyone except the selling investor.

An actively managed mutual fund, on the other hand, may have to sell fund securities in order to meet shareholder redemptions—this has possible capital gains consequences for all remaining shareholders at year-end.

Of course, as with any investment, if you sell an ETF at a gain, the normal tax laws still apply.

ETFs are a good investment vehicle for building a tax-efficient portfolio, regardless of what the future may hold. As the iShares report concludes – the tax man may still have to be paid. Just not as much.

– Michael Vermillion

November 4, 2008