Volatile markets have sapped some of the enthusiasm for active management, while the tax advantages of ETFs have grown more apparent.
Advisors and clients have learned that ETFs are less likely than mutual funds to generate tax bills for reinvested capital gains distributions.
As a result, U.S. ETF assets, barely over $100 billion in 2002, reached nearly $2.1 trillion at the end of this year’s first quarter, with some of that 20-fold increase coming from mutual funds.
“We have moved a large percentage of our equity mutual fund holdings to ETFs over the last decade in order to get ETF benefits,” said Kevin Reardon, a CFP and president of Shakespeare Wealth Management in Pewaukee, Wis. “ETFs have greater tax control than mutual funds, greater liquidity and the ability to hedge.”
ETF tax advantages also were cited by Vern Sumnicht, a CFP and the chief executive of Sumnicht & Associates, family wealth managers in Appleton, Wis.
“Because index-based ETFs typically don’t buy and sell securities, they don’t incur capital gains,” he said. “Therefore, they don’t need to distribute net capital gains to shareholders annually, so investors avoid the capital gains tax they would have to pay if they owned mutual funds.”
When Sumnicht’s firm opted for a passive index approach to investing, shifting from active management, reasons for using ETFs went beyond taxes to cost, flexibility and transparency.
“When you buy an index-based ETF, you know exactly what you are buying because ETFs typically mirror the securities held in the index. Many of the holdings disclosed quarterly by mutual funds weren’t actually held in the portfolio during the quarter,” said Sumnicht, who is also chief executive of iSectors, an ETF investment management strategist.
“We made the decision to replace some mutual fund assets with ETFs in December 2015,” said Van Pearcy, an advisor with Raymond James Financial Services in Midland, Texas. “We altered the rules for equity allocations in our discretionary portfolio models to include passive positions such as ETFs.”
Using low-cost index ETFs in the passive sleeve was appealing, according to Pearcy.
“After extensive due diligence and research, our investment committee set our equity allocation rule to maintain a 30%-to-50% allocation within the passive equity space in certain types of equity ETFs,” he said.
Meanwhile, Reardon said his firm hasn’t yet moved into bond ETFs, as that area is still developing.
“In a few more years, we anticipate having more bond ETF options to choose from,” he said.
Sheila M. Chesney, principal of Chesney & Co., a private wealth management firm in Sheldon, S.C., doesn’t use ETFs on the equity side, preferring individual issues.
“In fixed income, ETFs have replaced fixed income mutual funds in clients' portfolios,” she said.
Chesney uses ETFs for fixed-income holdings because they offer index-based breadth, low costs and tax efficiency.
“I believe that the return on fixed income, across the board and out to the end of this decade, will barely beat inflation,” she said. “Therefore, our fixed-income allocation is really a moderation of the portfolio’s total volatility and a liquidity position.”
If low-yield, low-upside bonds still have a place in clients’ portfolios, low-cost and low-tax ETFs may be a good fit.
Donald Jay Korn is a New York-based financial writer who contributes to Financial Planning and On Wall Street.
This story is part of a 30-30 series on smart ETF strategies.
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