ETF vs Mutual Fund

Are ETFs that advantages over mutual funds when taxes are embedded within? by Jason Zweig Thursday, April 22, 2010 Does ETF stand for “esoterically taxed fund”? Many investors may just have finished wading through the tax reporting on commodity or currency funds for the first time and found it a slog. They also may have learned that an investment’s taxation can by itself make the difference between a winner and a loser. Exchange-traded funds, or ETFs, are bundles of assets that resemble a mutual fund but trade on an exchange like a stock. Their structure has enabled many of them to avoid distributing taxable capital gains, earning a reputation for minimizing investors’ tax bills. But the mad dash in ETFs lately has been into “alternative assets” like currencies and commodities. The investment researchers at Morningstar track 108 such ETFs with a total of $80 billion in assets; 42 are less than two years old. These funds are taxed so differently, and at such higher rates than traditional investments, that many investors now wish they had looked before they leaped. “As ETFs have gone farther afield from stock indexes,” says Robert Gordon of Twenty-First Securities, “their tax efficiency and simplicity are getting left behind.” Analyst Mariana Bush of Wells Fargo Advisors has estimated that commodity ETFs can be taxed in six different ways and currency ETFs in eight. Commodity and currency ETFs often aren’t “funds” at all, but trusts or limited partnerships that pass income and gains through to their investors. The income or gains may come from foreign currencies or physical commodities – but also from money-market instruments, forward contracts, swap agreements, futures contracts or other derivatives. There, the tax treatment may be utterly alien to stock or mutual-fund investors, who are used to paying 15% on qualified dividends and long-term capital gains. U.S. Oil Fund, for instance, trades oil futures. The Internal Revenue Service requires open positions in futures contracts to be “marked to market” at year end. That means investors can owe capital-gains taxes on holdings the fund hasn’t unloaded yet – “regardless of [whether those investors] sold their shares during the tax year or not,” says U.S. Oil Fund’s chief investment officer, John Hyland. The fund is far from alone. At many other commodity and currency ETFs, paper profits are taxed at a blend of short-term and long-term capital-gains rates. That amounts to 23% for taxpayers in the highest federal bracket – on gains you haven’t even received. Under IRS rules, you may even be liable for taxes on mark-to-market gains booked by the fund as long as 30 days after you sold it. Or consider SPDR Gold Shares. The fund holds nearly 37 million ounces of gold, so the IRS taxes your capital gains at the 28% rate for collectibles – even if you have held your shares for more than one year. “We try really hard” to make sure investors are aware of that higher tax rate, says James Ross of the fund’s sponsor, State Street Global Advisors. The iPath single-currency funds, which track the British pound, the euro and the yen, are structured as exchange-traded notes, a form of debt. They accrue income as the value of each currency changes against the dollar. That leads to a tax treatment that Dave Nadig, director of research at Index Universe, calls “bizarre”: Although the funds pay out no income until sale or maturity, any accrued interest is taxed annually at your highest marginal rate. Any gain when you sell is also taxed as ordinary income, not at the lower capital-gains rate. “We have not gotten any negative feedback” from investors, says Christine Hudacko, a spokeswoman for iPath, because “we take care to highlight the different tax treatment.” Finally, ETFs organized as partnerships or trusts are likely to file a K-1 form, which can complicate your return and boost your tax-preparation bill. Lyle Benson, a certified public accountant at L.K. Benson in Baltimore, notes that his fee for preparing one client’s tax return doubled from 2008 to 2009. This year, the client handed Mr. Benson a half-dozen K-1s for ETFs. You shouldn’t invest in a commodity or currency ETF at all unless you “thoroughly understand what type of income the transaction will generate and what your tax rate will be,” says Robert Keebler, a CPA at Baker Tilly Virchow Krause in Appleton, Wis. That means plowing through the “Income Tax Considerations” section in the ETF’s prospectus. If necessary, get a tax adviser or someone at your brokerage house to explain it. With tax rates on the rise, you can’t afford not to know whether you are getting into a can of worms.

I’ll be perfectly honest. I’ve had a few pints and I was going to read your post but it seems quite long.

soddy1979 Wrote: ------------------------------------------------------- > I’ll be perfectly honest. I’ve had a few pints and > I was going to read your post but it seems quite > long. I feel drunk trying to figure out the first sentence of QJ_MBAs post… Are ETFs that advantages over mutual funds when taxes are embedded within? by Jason Zweig Thursday, April 22, 2010

Personally I own a couple Mutual Funds because of one of those people that believes, over the long term with the right people doing the right research, they can pick securities that will out preform the market. So far one of my mutual funds is doing good and the other is a lot more volatile than I though possible in a mutual fund.

Pretty informative article though, thanks for sharing.

Reggie Wrote: ------------------------------------------------------- > Pretty informative article though, thanks for > sharing. Agreed, great article.

personally, i feel picking undervalued small caps is the only place an MF manager can add meaningful alpha, in order to make an MF worth holding. i’d rather do an ETF or CEF otherwise. depends on the strategy being employed i.e. country-only funds, mkt neutral-replicates (hussman funds) etc.

One of the advantages of mutual funds is the dollar cost averaging option.

I wish I had invented the ETF - a license to print money

which one has higher licensing fee, ETF or Mutual Fund? Why?