Here's a reminder about two gifts for investors just in time for tax reviews and Christmas in July. Index Exchange-Traded Funds (ETFs) are managed funds bought and sold on a listed exchanges such as the ASX and they have tax benefits compared with unlisted and actively-managed funds.
Gift 1: Streaming of capital gains
The 2021/22 financial year ended with negative returns for many asset classes. In periods of such volatility, many investors have exited the funds they were in, waiting for calmer days. Such a strategy comes with the perils of market timing, but in unlisted managed funds, the tax liability for an investor who stays in the fund goes up as other investors leave. ETFs have a mechanism to mitigate this risk.
In unlisted managed funds, if an investor redeems from the fund, they leave behind their share of the tax liabilities on any capital gains that are realised. In an unlisted managed fund these tax liabilities will be attributed to the remaining investors.
This does not happen in an ETF. Investors sell their units on the exchange to other investors, or the market maker. A market maker is someone whose job is to ensure there are units available for investors to buy or sell. In an ETF this doesn’t happen because the withdrawal mechanism is different.
An investor who wants to withdraw from an ETF simply sells their units on ASX where they are purchased by other investors or an ‘Authorised Participant’. Only Authorised Participants may withdraw (redeem) from the ETF. If they do, the capital gains created by the withdrawal can (and will) be passed to the Authorised Participant rather than being left behind for remaining investors. The ETF therefore protects investors from the impact of redemptions by other investors.
Those who have had a bad tax experience with an unlisted managed fund will understand. An ETF won’t hit you with a large taxable distribution the way an unlisted actively managed fund can do due to client redemptions.
This tax efficiency is often an overlooked benefit of investing ETFs.
Gift 2 – Passive management and less trading
Passive ETFs hold a portfolio of shares or other assets that track an index. As a passive ETF’s portfolio is automatically determined by the rules of the index, its portfolio only changes when the index changes. The contrast to this is actively managed funds where the fund manager picks the shares that they think are going to perform the best.
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 generally 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. This brings forward capital gains.
To summarise:
- ETFs are generally a tax efficient investment vehicle because they minimise exposure to capital gains tax when other investors redeem.
- As passive funds, ETFs typically have low turnover and therefore generate lower levels of capital gains tax compared to actively managed funds.
AMIT and TOFA
For more tax details on AMIT (Attributed Managed Investment Trust) and TOFA (Taxation of financial arrangements), see Avoiding tax time dinosaurs.
While AMIT can be used to smooth income payments, the TOFA hedging rules smooth the tax liabilities for investors in a fund that hedges its currency exposure. Without it, currency hedging can lead to tax shocks.
Michael Brown is Finance Director at VanEck, a sponsor of Firstlinks. This is general information only and does not take into account any person’s financial objectives, situation or needs.
For more articles and papers from VanEck, click here.
We outline tax advantages in The Tax Advantages of ETFs which can be found on the ETF education page.