Low-cost exchange traded funds allow investors to maintain a laser-like focus on returns.
Here at Vanguard we are firm believers in the adage that when it comes to tax, ‘Don’t let the tail wag the dog‘. But at the same time we realise that tax is a key expense for many investors and minimising the tax you pay is a key determinant of investment performance.
In fact, Vanguard pioneered the reporting of ‘after-tax returns‘ as a more impactful way of measuring investment performance. Measuring performance on an after-tax basis means that investors can compare returns including the hidden costs of high portfolio turnover, this turnover often leads to bigger tax bills for investors.
ETFs are a great way to maintain focus on investment returns and minimise the tax you pay. Here are three ways they are highly tax efficient, no matter which tax bracket you are in.
- Franking credits are fully passed through to the investor. The dividend imputation system here in Australia is a key component of tax-efficient investing. Where Australian companies pay franked dividends, those franking credits are paid to the ETF, which are entirely passed through to ETF investors. Each quarter, the ETF distribution contains details of the amount of franking credit and the percentage of dividends that were franked.
- Index investing is low turnover investing. Portfolio turnover is where a fund sells shares it owns and buys other shares. This activity can trigger a capital gain within the fund, which can eventually lead to higher tax bills for investors. Minimal turnover within a portfolio not only reduces transaction costs (brokerage, market impact) but also minimises realised capital gains over the life of an investment. ETFs benefit from the intrinsic low turnover approach of indexing, and also benefit from a special feature which reduces the impact redeeming investors have on other investors in the ETF. This means that, generally, investors are only paying capital gains tax as a result of their own activities and not the buying and selling of others.
- Eligible for capital gains discounting. As a listed security, when an investor holds an ETF for longer than 12 months then they are eligible for capital gains discounting. This means the capital gains are reduced by half or a third, depending upon the tax status of the investor.
ETFs are not only tax-efficient investments, they are also highly transparent. At Vanguard we provide regular information to the market including the daily ETF Net Asset Value (NAV) and the ETF basket, which shows investors what they are invested in. This transparency allows investors to maintain a laser-like focus on their investment returns.
So next time you’re preparing your tax return, it’s worth remembering what difference ETFs can make to both your total cost of investment and your portfolio returns.