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Here's how the tax advantages of ETFs can boost returns

Nicki Bourlioufas  |  08 May 2017Text size  Decrease  Increase  |  

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There are several reasons behind the surging popularity of exchange-traded funds, including their ability to deliver tax advantages over actively managed funds.

 

Investors could be better off from a tax perspective by investing in passively managed exchange-traded funds (ETFs) rather than actively managed funds, but they need to check their ownership vehicle will deliver those benefits, according to experts.

Efficiency is a big reason ETFs are gaining in popularity. They are easy to buy and sell on a listed exchange and they enable investors to diversify their investments through a single security. They may also deliver taxation advantages over actively managed funds, which can add to investment returns.

"One of the biggest tax advantages of ETFs is that they are passive index funds, and therefore have incredibly low portfolio turnover. That maximises use of the capital gains tax (CGT) discount, and delays paying tax, meaning you can keep compounding returns on your money for longer," Morningstar research analyst Alex Prineas says.

ETF provider VanEck has released a research paper titled "The tax advantages of ETFs," which says "the tax problem with the active management process is that it causes a lot of shares to be sold each year, whereas the index fund process does not. The more shares that are sold by the active fund manager in a year, the higher the investor's capital gains tax liability for that year".

The mechanism by which investors withdraw from the ETF provides another key tax advantage over managed funds.

"In unlisted funds, the units held by the withdrawing investor are cancelled and a portion of shares in the fund are sold to pay the investor out. The sale of the shares creates a CGT liability inside the fund. The problem is that this CGT liability doesn't fall on the investor who is withdrawing. It falls on the investors who are still in the fund," the VanEck paper says.

"If a lot of investors withdraw from the fund in the same year, this mechanism creates a CGT burden which can become significant for the remaining investors.

"In an ETF this doesn't happen ... An investor who wants to withdraw from an ETF simply sells their units on the ASX. The sale of units does not require a sale of shares in the fund because the ETF units are not cancelled, they are purchased by other investors."

Prineas makes the point that not all ETFs deliver tax benefits, particularly those that are more actively managed.

"Morningstar has analysed ETFs with style tilts and found that some of them have portfolio turnover higher than some active funds. So, while ETFs can offer tax benefits, it is certainly not the case with all ETFs," he says.

Prineas points to strategic beta ETFs, which, rather than simply weighting stocks by market capitalisation as traditional ETFs do, are based on indices which are specifically constructed to meet a particular investment objective or strategy.

"Vanguard Australian Shares High Yield ETF (ASX: VHY) would be an example of a strategic beta ETF with significantly higher turnover than passive funds, and higher than some active funds, however, it is by no means the only one," he says.

"Commendably, Vanguard recognised this, and in 2014 they amended the investment process from quarterly portfolio rebalancing to half-yearly rebalancing, to reduce portfolio churn and turnover."

ETFs can also deliver to investors the benefit of fully franked dividends. When an ETF holds shares that pay franked dividends, the franking credits flow through to investors to reduce their tax liability. The level of franking credits that flow out of an ETF depends on its underlying share portfolio and how often franked dividends are paid.

If, for example, you invest in an ETF that has bought shares in one of the big banks, the franking credits investors receive can be significant and are equivalent to the tax the bank has already paid on its profit.

How you own the ETFs is also important. According to Chris Brycki, founder of digital investment adviser Stockspot, owning ETFs in your own name means you get full access to franking credits.

"But if you invest in ETFs via another investment service, a separately managed account, or a managed investment scheme which uses a custody or trustee structure, tax can get more complex. You may or may not get the full benefit of franking credits," says Brycki.

"It's crucial to ask if you're receiving the full benefits of franking credits on your Australian ETF income, the 15 per cent withholding tax benefit on your overseas income, and the 50 per cent capital gains discount on investments held for 12 months.

"Platforms and investment services which use an overseas custodian or a managed investment scheme structure may not be able to pass on all of these important tax benefits to you. These tax benefits can add up to over 1 per cent a year in extra returns, so you don't want to miss out on this tax value."

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Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.