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The advantage mutual funds have over ETFs

Given the proliferation of passive index funds and exchange traded funds, it is no wonder that the active versus passive debate rages on.

Although ETFs provide index returns and greater tax efficiency than their mutual fund brethren, they miss an important factor that leads to enhanced returns: tax loss harvesting.

Simply put, in a given index, such as the S&P 500, a group of stocks will go up or down based on a multitude of factors, including earnings, market conditions and sentiment. In an actively traded portfolio, the manager can take advantage of these factors and sell the basket of stocks at a loss and purchase a basket of different stocks to maintain equity exposure.

This trade results in a tax loss, which can be used to offset capital gains. This is the age old adage of cutting losses short and letting gains run.

In addition, the short-term losses can be used outside the portfolio where there are capital gains. In many cases, the harvesting of tax losses adds 1% to 2% to the overall return of the portfolio above the index.

Through a consistent approach of tax management to harvest tax alpha, advisors will boost after-tax performance of portfolios and increase clients’ wealth.

As David Swensen, manager of the Yale University Endowment, pointed out in regard to taxes: “Why are the tax bills so high? Because turnover’s too high. The mutual fund managers are trading the portfolios as if taxes don’t matter, and taxes do matter. And they’re trading the portfolios as if transactions cost and market impact don’t matter, and they do matter.”

So, those holding large positions in passive equity indexes should consider an active manager who uses tax management strategies. The tax benefits will likely outweigh the costs, and clients will be well-served.

This story is part of a 30-30 series on tax-advantaged investing.

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