As tax season comes to a close, you realize exactly
how much you paid in taxes and naturally will ask the
question, “what can I do to reduce my taxes next
The very short and simple answer to this question is
to consider a portfolio of low-fee, thoughtfully
constructed, index mutual funds or exchange-traded
funds. Yet not all of them do the job for you. Here’s
how to find the right ones.
Index Funs and ETFs
An index mutual fund is a passively managed fund
that tracks the performance of a certain index, such
as the Dow Jones Industrial Average, or a broad bond
or commodity index.
An ETF is similar to an index mutual fund, but is
traded on the stock exchanges, just like a stock.
Rather than buying all of the stocks in the Dow Jones
Industrial Average or Standard & Poor’s 500, you can
simply own an ETF that tracks that index.
Because index mutual funds and ETFs are not
actively managed, their fees are generally low – or
lower than actively managed mutual funds. Also, their
low turnover – how frequently stocks are bought and
sold within a portfolio – can provide additional tax
benefits as excess trading activity creates the
potential for more taxable events.
Consider these three aspects before buying an index
fund or ETF:
Decide what you want to own. This is obvious, but not
simple. Choosing from the broad number of stock
index providers can be overwhelming (the Dow, S&P
500, Russell 2000, MSCI, FTSE, etc.). Therefore, it’s
important to understand what markets, countries,
regions, industries, sectors and stocks the index fund
you buy contains.
Is your goal to own large stocks, small stocks or both?
Do you want U.S. stocks, international, emerging
market or all of the above?
Just as important, the fund you choose should closely
adhere to its benchmark index. The more closely the
investment matches that of the desired exposure, the
Like actively managed mutual funds, every index fund
and ETF has management fees. These fees range from more than 1% to as low as 0.00% per year.
That is not a typo – there are index funds that have
zero management fees. And of course, the lower your
investment fees, the more of the returns you keep.
Another factor affecting cost is liquidity, or put simply,
how easy it is to buy and sell the investment. With mutual funds, this is not an issue because they are
bought or sold at the end of each day. For ETFs,
which are traded like stocks, their liquidity is a more
important issue. If an ETF is thinly traded, to buy or
sell, it may be more costly.
Tax Cost Ratios
This measures how much the taxes you pay on
distributions reduce a fund’s return. The lower this
number, the better. Morningstar, an industry leader in
tracking investments, offers this information for free.
Here is a great explanation taken directly from
“Like an expense ratio, the tax cost ratio is a measure
of how one factor can negatively impact performance.
Also like an expense ratio, it is usually concentrated in
the range of 0-5%. 0% indicates that the fund had no
taxable distributions and 5% indicates that the fund
was less tax efficient.
For example, if a fund had a 2% tax cost ratio for the
three-year time period, it means that on average each
year, investors in that fund lost 2% of their assets to
If the fund had a three-year annualized pre-tax return
of 10%, an investor in the fund took home about 8%
on an after-tax basis. (Because the returns are
compounded, the after-tax return is actually 7.8%.)”
The Challenge for You
Now that you know what you should keep in mind
before investing in index mutual funds or ETFs, here
is the tricky part:
There are over 5,000 ETFs, and close to 2,000
of them are based in the U.S.
And when you add the number of mutual funds to the
number of U.S.-based ETFs, that number is over
Talk to your financial advisor to find the right ones,
along with the right combination, to fit your desired
asset allocation and financial plan.
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