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Harnessing ETFs for their tax efficiency

Arian Neiron  |  22 Jun 2016Text size  Decrease  Increase  |  

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As we approach the end of the financial year, investors start to think about their tax liability.

Most investors using exchange-traded funds are aware of the key benefits such as diversification, transparency and low cost, but one of the most unknown advantages of ETFs is their tax efficiency.

Why are ETFs tax efficient?

Passive strategy means lower turnover--most ETFs track an index. Typically, indices are low turnover, which means they don't change the weightings or the companies regularly.

Conversely, an actively managed fund turns over the portfolio frequently, creating a higher capital gains tax liability each year.

Many investors do not look at the after-tax return, instead they typically only look at the gross performance return. It is important to consider after-tax returns when comparing investment products.

Market mechanisms

The mechanisms for determining an investor's share of the tax liability generated by an actively managed fund can punish investors who invest shortly before 30 June.

Often investors get a shock at the size of the June distributions they receive, particularly if they have only recently invested in the fund.

Their tax bills are typically disproportionate to the return on their investment. ETFs do not inflict this pain, partly due to the low turnover but more because of the role of market makers.

When investors sell ETF units it doesn't result in the fund having to sell shares out of the portfolios as is the case with an unlisted fund. This is where the large capital gains tax liabilities come from.

With an ETF, various professional trading companies take a role as a market maker, creating the ETF units that are offered to investors on the ASX.

If investors sell out of the ETF and a market maker has more inventory than it needs, then the market maker redeems the excess.

The clever bit is that there is a mechanism which enables the market maker to take the capital gains generated by the sale of shares out of the portfolio, shielding the ordinary investor from the associated tax liability.

Unlike an ETF, investors in unlisted funds may bear the capital gains tax liability if they sell out of the fund.

There have been exceptional circumstances where an unlisted managed fund has had a large investor redeem from the fund, creating what is called a "last man standing" event.

That is, the investors who are left may bear an enormous capital gains tax liability in respect of the departing member's investment. The market maker mechanism for ETFs means this cannot happen.

Thus investors are truly treated equally.

Dividend imputation and franking credits

The proliferation of ETF choices today allows investors to target all types of portfolios that they may consider to be tax-effective, including fully franked dividends.

Australians' love affair with dividend franking credits is well known, and unlike many other countries around the world, dividends here are not "double taxed".

With the cash rate at a record low, Australian investors have been turning their attention to dividend-yielding shares and seeking out associated franking credits.

The appeal of franking credits is well understood by Australian taxpayers, particularly those who have a zero or concessional tax rate.

For them, there is nothing more gratifying than receiving a cheque from the ATO at the end of the financial year.

There are a range of equity income ETFs on the ASX that pay out distributions and any associated franking credits.

However, the percentage of franking credits significantly differs greatly among them. Only one ETF seeks to deliver distributions with 100 per cent franking credits--the VanEck Vectors S&P/ASX Franked Dividend ETF (FDIV).

Seek advice

In the pursuit of tax-efficient portfolios, ETFs are one of the best investment products around.

With their distributable income and associated franking credits they are useful tools for end of financial year strategies.

Investors should always consult with a financial adviser or their accountant to understand their tax circumstances and the benefits ETFs may provide to their individual portfolio.

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Arian Neiron is the managing director of VanEck Australia. Established in 1955, VanEck is one of the world's largest ETF providers. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.

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