Take Solace in Tax Efficiency

As Congress and the president continue to dither on a fiscal cliff deal, investors are clearly getting very nervous about their future tax rates.

According to data from Lipper, investors pulled $14.5 billion from equity mutual funds in October. And while we’re still awaiting the final tally for November, weekly data suggest it’s likely at least as much money flowed out of equity funds last month.

Although traditional equity funds have suffered strong outflows over the past couple months, equity-oriented exchange-traded funds (ETF) have enjoyed strong inflows. While the inflows to equity ETFs don’t quite match the outflows from equity funds, it’s pretty close.

One possible explanation for this behavior is that investors are betting that capital gains taxes will be going up next year, so they’re abandoning mutual funds for the greater tax efficiency of ETFs.

Most traditional open-end mutual funds still use active management. While some fund managers are more active traders than others, many attempt to enhance their returns–or at least the appearance of their holdings–by trading into stocks with upward momentum at quarter- and year-ends. As they trade, they create capital gains tax bills for their investors, especially if they’re paring positions to meet investor redemptions.

By contrast, while active management is a growing trend in the ETF world, most ETFs are still passively managed. As a result, their portfolios tend to experience just a fraction of the turnover of a mutual fund. On top of that, thanks to their more tax-efficient structure and ability to make in-kind transactions, ETFs rarely create unexpected tax bills for their investors.

Dividend-focused funds have come under particular pressure lately from outflows. While most dividends are currently taxed at 15 percent, they could rise to almost 19 percent next year or even as high as 43.4 percent if the Bush tax cuts aren’t extended. At the same time, the long-term capital gains tax could hit 23.8 percent.

Given that unpleasant backdrop, it’s hardly surprising that investors are beginning to get concerned about the potential tax liability of their holdings. But that uncertainty doesn’t mean you should necessarily start making wholesale changes to your portfolio just yet.

If you’re a long-term investor and plan to hold your existing positions for another 10 years or longer, it probably doesn’t make much sense to start adjusting your holdings at this point. It’s tough to predict what the tax situation will look like just a few years down the road, much less a decade out. In fact, it is quite possible that taxes could be even lower.

On the other hand, if you plan on selling some investments over the next few years in order to meet income needs, fund a major purchase or send a child to college, you might want to consider transitioning at least some of your positions to more tax-efficient vehicles now. That way, you’ll be able to hang on to more of your existing gains, while facing a lower tax bill on future gains down the road.

However, tax considerations can quickly get rather complex. So your best bet is to talk to your accountant or other tax professional before making any changes, since they’ll have a better understanding of your individual tax situation.

If nothing else, 2012 will be a banner year for CPAs.

What’s New

Last week, PowerShares S&P 500 Downside Hedge Portfolio (NYSE: PHDG) started trading. The ETF is Wall Street’s latest attempt to build a better hedge against market downturns.

Like most S&P 500 index funds, the new ETF will invest primarily in S&P 500 securities when market volatility is low. But as volatility creeps up, its managers have the flexibility to allocate assets to VIX (Chicago Board Options Exchange Market Volatility Index) futures. The fund also has the option of moving fully into cash in the event that its benchmark S&P 500 Dynamic VEQTOR Index drops 2 percent or more over the course of five trading days. The ETF will then remain in cash until the benchmark’s return rises above a 2 percent loss.

While PowerShares S&P 500 Downside Hedge Portfolio isn’t the only ETF to offer downside protection against the S&P 500–there are currently at least six other products available–it is one of the cheapest. Its annual expense ratio is just 0.39 percent. It’s also the only ETF in this niche that has the ability to shift its entire portfolio into cash.

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