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Advisor ETF Insights

The ETF tax advantage

Tax-efficient exchange-traded funds offer investors another way to keep their costs down and profits up

By: Joel Schlesinger

Date: May 23, 2017

It seems everyone is talking about exchange-traded funds (ETFs) these days – with good reason. These low-cost investments, which generally track the performance of an underlying index (such as the S&P/TSX Composite Index), are rapidly gaining in popularity. According to the Canadian ETF Association, Canadian-listed ETFs ended March 2017 at $122.9-billion in assets, after six consecutive months of asset growth.

While many investors and financial advisors are turning on to ETFs because of the low-cost, passive strategies they offer, these investments offer another in-demand advantage: tax efficiency.

“ETFs are tax-efficient because you typically have less cash moving in and out of the ETFs and less turnover,” says Krista Matheson, head of ETFs and structured products with Manulife Investments.

As more investors look to their advisors for guidance about ETFs, their tax efficiency in a non-registered account is an important point that shouldn’t be overlooked, adds Ms. Matheson. The trouble many advisors may face is that explaining the nuances is not easy.

To put it as simply as possible, ETFs have a few mechanisms that add to their tax efficiency relative to a traditional mutual fund.

For one, ETFs are traded on the secondary market between a buyer and seller, so this results in one taxable transaction for the seller: a capital gain (or loss).

“People who are buying and selling in and out of the fund can just transact on the market, which doesn’t affect the holdings of the fund,” says Ms. Matheson.

In other words, none of the underlying assets need to be sold, which would potentially trigger a whole lot of small, taxable events.

Some ETFs offer added tax savings because they employ derivatives to emulate index performance rather than owning the actual underlying stocks, says Ms. Matheson.

But with most ETFs, the tax savings are related to the fact that less cash changes hands when buying, selling and creating units. This is due to the ability to do a subscription or redemption “in kind,” which means the ETF takes in stocks rather than cash, or in the case of a redemption, gives stocks rather than cash. What this means, says Ms. Matheson, is that the ETF does not need to purchase or sell those underlying securities which again, results in less cash transactions within the ETF.

Investment blogger Kyle Prevost, who writes about ETF strategies on the investment blog Young and Thrifty (youngandthrifty.ca), agrees that ETFs generally trigger far fewer taxes compared with mutual funds because they involve much less buying and selling inside the fund.

Mr. Prevost notes, however, that “for most Canadians who are just investing in registered accounts, there isn't a huge difference.”

Ms. Matheson agrees that for investors holding ETFs in an RRSP (registered retirement savings plan) or a TFSA (tax-free savings account), the tax advantages are not a selling point. But when it comes to a taxable account, advisors should certainly discuss the efficiencies ETFs can provide.

The savings may be rather small on their own, she notes, but taxes can add up over time and act as a drag on performance for clients’ non-registered assets.

And for advisors and their clients, it can simplify their tax reporting, says Ms. Matheson.

Sponsored by Manulife

Commentary is for general information purposes only and should not be relied on for specific financial or other advice. Opinions expressed are subject to change based on market and other conditions. Commissions, management fees and expenses all may be associated with exchange traded funds (ETFs). Investment objectives, risks, fees, expenses and other important information are contained in the prospectus, please read it before investing. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

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