How Tax-Friendly ETFs Keep Getting Friendlier

No one likes taxes. Which is why investments tailored to maximize tax relief seem to be the next big trend.

Exchange-traded funds have had a record year so far, thanks in no small part to their tax efficiency. But just how tax-savvy can these products get? Issuers are racing to find out, launching new strategies that push the boundaries of what tax shortcuts can achieve. Equity ETFs like the iShares Core S&P 500 ETF (IVV), which limit taxable gains, have taken off in recent years, and earlier this month, Kurv Investment Management launched its US Large Cap TaxOptimized ETF (LCTO), which tracks the S&P 500 while trying to boost after-tax income. Another reason behind the push for tax-friendly products may be a series of Securities and Exchange Commission decisions stemming back to the ETF Rule.

“In 2019, the SEC made a rule change that allowed for these more sophisticated strategies to be in an ETF format,” said Howard Chan, chief executive of Kurv. “A second rule change allowed for some deferral of taxes of various instruments in the portfolio. So it’s sort of like the perfect storm.”

Tax Me If You Can

ETFs are more tax-efficient than their mutual fund counterparts for a few key reasons. One is their relatively low turnover, which matters because when fewer stocks are sold, there are lower capital gains taxes, meaning investors can rest assured that their products are likely to only incur those taxes when they sell. Most strategies passively track indexes, which don’t trade as often as active products, although the latter are gaining ground quickly. But there’s a limit on what standard index funds tracking things like the S&P 500 can return, meaning the next logical avenue for yield growth is in structuring the products differently so as to minimize taxes, Chan said.

There are a few different types of tax-efficient strategies available to investors:

• One is the “traditional kind,” Chan said, such as tax-advantaged assets in the form of municipal bonds.
• Another is option income strategies, which generate distributions that often have a lower tax rate than ordinary income.
• A third is funds that use tax loss harvesting mechanics such as the 130-30 strategy, which entails allocating 130% of a product’s capital to long positions while shorting 30% of its underperforming stocks.

“You’ve seen the outgrowth of [tax-loss harvesting] that has been extremely popular for the last two years,” Chan said. “All of these combined shows momentum.”

The 351 of It All: So-called 351 exchanges are symptomatic of the tax-advantaged frenzy, Chan said, since many people have held fast-growing stocks like Microsoft and Google for many years, but these companies’ large capital gains can hinder returns.

“We get this feedback from advisors … that they can’t really move any of these positions because if they were to sell out of it, they would have to pay a huge amount of tax liabilities,” he said. “What we [will] see in the second half is that obviously as the technology sector continues to do well, that hidden tax liability just continues to grow.”