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Exchange traded funds have an edge over regular mutual funds on tax efficiency

by Wayne Cheveldayoff, 2004-09-02

On the issue of tax treatment, Canadian mutual funds and exchange traded funds (ETFs) have many similarities. But there is an important difference with respect to capital gains that can give ETFs the edge.

Here is how Howard J. Atkinson, an executive at ETF-manager Barclays Global Investors Canada Ltd., introduced the subject in a recent book entitled, The New Investment Frontier II, A guide to Exchange Traded Funds for Canadians:

“I once heard an accountant say that for most investors the only thing you can do legally to mitigate taxes is to deduct, divide and defer. The three ‘D’s’ he called them. Deduct the maximum allowable expenses, divide the income by income splitting as best you can, and defer paying taxes for as long as possible. One of the ways to defer tax is to avoid realizing your capital gains every year. ETFs are particularly good at letting you control your capital gains.”

Let’s take a look at how this works for individual investors who have the money to invest in ETFs or mutual funds outside of their registered plans (RRSPs, RESPs, or RRIFs).

Most of the made-in-Canada ETFs are invested in stocks that make up an index and they therefore generate some dividend income and capital gains – and possibly some interest and foreign income – just like conventional equity mutual funds.

The income (including the capital gains generated from trading within the ETF) is distributed and flows through to the ETF holder, just like it does to the mutual fund holder, and at the end of the year, the ETF administrator sends out a T-3 detailing the nature and amount of income generated that year.

A key difference is that since ETF managers do so little buying and selling within the fund compared to what active managers typically do within the equity mutual funds they manage, the amount of capital gains flowing out to investors is generally lower for ETFs than it is for mutual funds (although it is not always the case since some equity mutual funds have very low turnover).

As the higher capital gains are distributed from mutual funds, they are taxed, and this leaves investors with less after-tax with which to build their wealth.

As the accountant might have put it, many mutual fund holders are losing out on the third ‘D’, namely “defer paying taxes as long as possible.”

To put it another way, the equity mutual funds that are actively traded and are generating out-sized capital gains distributions have to perform better than ETFs on a total return basis just to equal the after-tax return of ETFs.
It is important to note that what is being discussed here are the capital gains generated by trading within the funds, not the capital gains generated by the buying and selling of the units (either ETFs or regular mutual funds).

The potentially better tax efficiency of ETFs is one of the reasons, in addition to lower annual management fees (as low as 0.17 per cent for ETFs versus 2.5 per cent or more for equity mutual funds), that investment advisors sometimes recommend ETFs to certain types of investors.

ETFs may not be better for all investors because there are other considerations as well, such as the commission costs of purchasing ETFs, which in Canada are traded on the TSX. Such commission costs make ETFs less suitable than mutual funds for small-sum monthly investment plans.

Many individual investors feel more comfortable if their money is being actively managed and with good reason. In the 2000-2002 bear market, many actively managed mutual funds outperformed the index-linked ETFs.

Barclays is the main issuer of ETFs in Canada, with 12 listed on its website at www.iunits.com.

The Barclays’ I-units are linked to several broad and narrow indexes, including indexes for the S&P/TSX 60 and gold, energy, technology and financial stocks and five-year and 10-year Canadian bonds.

Investors also have access on the Barclay’s site to a research paper by Price Waterhouse Coopers entitled “Understanding the Tax Implications of Exchange Traded Funds” (click on investor resources, then research papers).

This paper is a must-read for any investors thinking about or already investing in ETFs outside of registered accounts, especially if the investments include ETFs issued in the United States. The taxation of U.S.-based ETFs is complicated by the fact that U.S. ETFs are corporations (whereas Canadian ETFs are mutual fund trusts) and U.S. ETFs don’t specifically separate capital gains from other income in reporting distributions.

Also, since owning a U.S. ETF is the same as owning a U.S. stock, there are U.S. estate tax considerations for larger holdings.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff