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Chilling Capital Gains

Zombies and witches. Screams and screeches. Halloween? Yes, I did take my kids trick-or-treating—after all, I make out, too, since my transportation fee is modeled after the hedge fund industry: two pieces of candy immediately and 20% of the total take for later.

In this case, however, I am actually talking about the apocalyptic screams that come out this time every year surrounding the specter of taxes eating into your mutual fund and ETF returns. The real crazies come out of the woodwork, trying to confuse and scare you with what amounts to little more than just a lot of fake blood.

When it comes to discussions on capital gains distributions, and tax efficiency more generally, I always try to communicate three things:

  1. What matters is how much you keep, not how much you pay in taxes.
  2. If you invest in low-cost funds, you are very likely to owe more in taxes, and that is, generally, a good thing.
  3. Capital gains distributions from taxable bond funds can be more tax-efficient than no capital gains distributions.

After-tax returns, tax-efficiency statistics, and costs

The first two points are best illustrated with a simple hypothetical example. Two ETFs invest in the same underlying securities that generate a total return of 7% before expenses, of which 2 percentage points represent dividend income. The only difference between the two ETFs is their expense ratios: ETF A charges 0.25% while ETF B charges 0.10%. Consider the following return summary, assuming distributions of dividends and capital gains are taxed at 15%:

By these measures, ETF B appears to be more tax-efficient in that the investor earns more on an after-tax basis, which is what the investor keeps. Let’s look at the supposed measures of tax efficiency that are often presented, however:

If you were presented with only these statistics, you would see that investors in ETF A paid less of their return in taxes and, thus, had a higher “efficiency ratio.”  Yet, as we saw, investors in ETF B earn higher after-tax returns.

What’s going on here? The usual tax-efficiency indicators don’t account for cost differences. Fund expenses are deducted from income before distributions are made to shareholders.

As investors, then, your clients pay more in taxes on a lower-cost fund, but they also keep more. Instead of paying all the higher cost to the ETF or fund provider, they keep the expense ratio difference in the form of higher pre-tax returns and the net-of-tax difference as higher after-tax returns.

The next time the tax-efficiency zombies try to show you tax-efficiency statistics, recognize this could be a trick in which other factors, especially costs, might provide a different perspective.

Capital gains distributions and taxable bond funds. A treat?

Over the last several years, the majority of Vanguard’s taxable bond ETFs have distributed capital gains while our equity ETFs have not distributed a gain. Similar results are expected for 2014.

Say what? A capital gains distribution! The tax-efficiency equivalent of the Wicked Witch of the West! Run, Toto! Run!

This knee-jerk reaction about capital gains distributions being a bad harbinger of tax inefficiency is quite common, yet it may not hold water, especially when considering taxable bond funds.

Counterintuitive? Yes, but think about the two main sources of improving after-tax returns from a financial planning perspective: income deferral and converting higher-taxed income into lower-taxed income. Not distributing a capital gain represents the deferral strategy in that you pay taxes later rather than today. That strategy works very well when tax rates are the same or lower in the future.

However, taxable bonds provide an opportunity to convert higher-taxed interest income into potentially lower-taxed capital gains. A bond’s price is the discounted sum of its future cash flows. (That’s why bond prices rise when market yields decline.) By selling the bond with a higher coupon and reinvesting in a lower-coupon bond, you may realize a long-term gain taxed at a preferential rate now while forgoing higher future income taxed at much higher ordinary-income tax rates. That is often a very tax-efficient strategy: pay less tax now to avoid much higher taxes in the future.

So when you hear that witch cackling about evil capital gains distributions in taxable bond ETFs, just close your eyes, click your heels together three times, and think to yourself, “There can be lower tax in gains. There can be lower tax in gains. There can be lower tax in gains.”

Manage tax efficiency at the portfolio level

Of course, discussing capital gains distributions in taxable bond ETFs is often moot anyway. The best practice for clients looking to maximize a portfolio’s after-tax return is usually placing taxable bond funds first in tax-advantaged accounts, where distributions don’t matter one iota in terms of the difference between pre-tax and after-tax returns. That way one can keep taxable account investments geared toward broad-based, low-cost, tax-efficient equity investments.

So when portfolios are structured for tax efficiency, the existence of a taxable bond fund or ETF in a taxable account (at least for high-income investors) should be about as elusive as Linus finding the Great Pumpkin.

In short, the next time that trick-or-treaters knock on your door wanting to help improve your portfolio’s tax efficiency, don’t hand over your candy too quickly. Instead, check to see if the costumes they are wearing are legit.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

This information does not constitute legal or tax advice. We recommend that you consult a tax or financial advisor about your individual situation.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

© 2014 The Vanguard Group, Inc.  All rights reserved.  Used with permission.

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