We explain the basics of growth and value investing. Also, Wes Gray, Executive Managing Member at Alpha Architect, spotlights the ValueShares US Quantitative Value ETF.
Podcast: Play in new window | Download
Podcast: Play in new window | Download
Podcast: Play in new window | Download
Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show “The ETF Store Show“.
The various reasons why investors continue to pull money out of actively managed mutual funds and invest in ETFs have been well-documented. From the high cost of owning mutual funds to their consistent underperformance to their lack of transparency, mutual fund investors are recognizing that they may not be getting what they pay for. However, another reason investors are shunning mutual funds – and one that doesn’t receive nearly as much fanfare – is the relative tax inefficiency of mutual funds compared to ETFs. While tax savings may not garner the headlines that fund fees and performance do, they can have every bit as significant an impact on your investment returns. As the end of the year approaches, now is the time to review investments held in taxable accounts to avoid an unpleasant surprise come tax time.
Understanding the tax inefficiency of mutual funds compared to ETFs requires some additional explanation (which can be found here), but the bottom line is this: if you invest in ETFs, you have more control over your tax bill. With mutual funds, if you own a particular mutual fund and another shareholder wishes to sell their mutual fund shares, you could be penalized with a taxable capital gain distribution – even though you didn’t take any action. If other investors panic and sell their mutual fund shares during a brief market downturn (like we recently witnessed), that could trigger a taxable event for you. Or, consider the recent departure of Bill Gross from Pimco. According to a recent Reuters article, the flagship Pimco Total Return Fund saw nearly $50 billion in redemptions after Gross’ departure. In order to meet those redemptions, Pimco was forced to sell underlying bonds held by the fund to raise cash to give to shareholders – and bonds have done pretty well over the last few years. By law, any capital gains on those bonds must be distributed to all shareholders. If you hold the Pimco Total Return fund in a taxable account, you are on the hook to pay taxes on those capital gain distributions. So to recap, in this case, because a mutual fund manager decided to switch jobs, you get hit with a tax bill.
There are many other scenarios where a mutual fund could distribute large capital gains – including when your funds have suffered large losses, but they all come down to the structure of the mutual fund. In contrast, if a shareholder wishes to sell shares of an ETF, they simply place a trade on the exchange – typically with no impact on other shareholders. In addition, the ETF structure itself lends to greater tax efficiency because when ETF shares are redeemed, the underlying securities are delivered “in-kind”. This means shares of the underlying stocks are exchanged for shares of the ETF with no taxable event. A benefit of this process is that ETF providers can shed their lowest cost basis shares of stocks (which have the largest capital gains). Mutual funds don’t have this luxury. To be clear, there are instances where ETFs may pay capital gain distributions, including if a wave of selling results in ETF redemptions, but those instances are few and far between and the impact is typically muted compared to mutual funds.
Consider that last year, 99% of iShares ETFs paid no capital gains. iShares is the largest ETF provider in the world, offering nearly 300 U.S.-listed ETFs covering a wide variety of asset classes. And make no mistake about it, taxes can have a big impact on your investment returns as shown in following chart from iShares:
The long-term average annual tax cost for stock mutual funds over the past 10 years was 0.9%. The average annual tax cost for bond funds over the same period was 1.6%.4
3Source: BlackRock. For illustrative purposes only. Does not include commissions or sales charges or fees.
4Source: Morningstar, as of 3/31/14. “Tax cost” is a Morningstar measure of the impact of taxes on capital gains and income distributions on performance. Averages are calculated using the oldest share class of all Open-End Mutual Funds available in the U.S. (excluding municipal bond and money market funds) with 10 year track records as of 3/31/14.
Just a 1% difference in tax cost (note that iShares found the average annual tax cost for a mutual fund was 1.3%), yielded more than a $20,000 difference in your account balance over 10 years! $20,000! And this doesn’t account for any reduction in investment costs by using ETFs or the avoidance of mutual fund manager underperformance.
Over the next several weeks, mutual fund companies will begin reporting 2014 capital gain distributions. Already, many have posted projected capital gain distributions. For example, American Funds, one of the country’s largest mutual fund companies and provider of the popular Growth Fund of America, expects some of their mutual funds to distribute up to 12% of their current share price as a capital gain. If you hold mutual funds set to distribute large capital gains in a taxable account, it might make sense to sell these positions before getting hit with capital gain distributions. If you are looking to purchase a fund in your taxable account, you should check to ensure the fund isn’t set to pay a large capital gain distribution. Perhaps most importantly, if you are not currently investing in ETFs in your taxable account, it may be time to take a closer look. While lower costs and avoidance of active manager underperformance are certainly important, there is nothing worse than paying money to Uncle Sam because of the actions of less disciplined shareholders or a mutual fund manager looking for greener pastures.
The following was written by Jeremy Schwartz, Director of Research at WisdomTree. Listen to Jeremy’s most recent interview on “The ETF Store Show” here.
The Mauldin Economics team released a headline-grabbing report in late October called “The Ticking Time Bomb of the Strong US Dollar.” Its author warns readers, “You’re going to hear hundreds of US multinational companies blame their profit shortfalls on the strong dollar.”1
Typically, if a company’s home currency is weakening compared to the currency where the company’s sales are generated, this will have a positive effect on sales and profitability, and if the home currency is strengthening, it could negatively impact sales and profitability. This is the dilemma Japanese companies faced for many years as they fought the uphill battle of a strengthening yen. The Mauldin team put it quite nicely in reference to the latest U.S. dollar surge:
• “Top Line Pain: A strong dollar raises prices for foreign customers and those higher prices can negatively affect demand.
• Bottom Line Pain: The value of overseas sales declines when translated back into US dollars.”2
The recent U.S. dollar strength is certainly being felt at some multinationals, but the moves may be just the beginning. See the latest warnings:
The Coca-Cola Company
“Although the currency headwind on operating income was in line with the outlook provided last quarter, foreign currency unfavorably impacted earnings per share (EPS) by 6 points due to additional currency headwind related to remeasurement gains/losses recorded in the line item Other income (loss) — net.”
Philip Morris International
In the most recent earnings release, CEO Andre Calantzopoulos stated that “currency headwinds have stiffened.” Later in the report, the company quantified the impact of currency by forecasting “an unfavorable currency impact, at prevailing exchange rates, of approximately $0.72 per share for the full-year 2014 compared to unfavorable currency of approximately $0.61 per share in the prior guidance.”4
The Procter & Gamble Company
“P&G reiterated its organic sales growth and core earnings per share growth guidance ranges for fiscal year 2015. P&G added that the quarterly profile of earnings will be heavily influenced by the variation of foreign exchange impacts from period-to-period. The Company expects significant negative sales and earnings impacts from foreign exchange in the October-December 2014 quarter.”5
Strengthening Dollar Can Negatively Impact Revenue of U.S. Multinationals
We are working to quantify the impact on S&P 500 Index earnings from a move in the U.S. dollar, but market data is quite clear: the S&P 500 has traded quite inversely to the currency moves over recent years, and it has become increasingly negatively correlated. Recall, this is very much like the situation in Japan, where the market and currency tended to move in the opposite direction. The reasons here in the United States also may be similar in nature to those in Japan. A growing share of revenue and profits for U.S. corporations comes from overseas—and that share seems only likely to increase with globalization of the economy. Of course, there is also a safe-haven association with the U.S. dollar, and moves out of equities during periods of risk aversion have benefited the U.S. dollar. But on a companyfundamental and earnings basis, there is some connection, as the company reports above illustrate.
Three-Year Correlation of U.S. Dollar to S&P 500 Index
Who Benefits from a Strengthening Dollar?
• International Equities: Foreign multinational companies have the potential to benefit from a strengthening dollar because their products become less expensive to U.S. consumers, possibly increasing sales. These companies also benefit as their foreign sales are translated back to their home currency through a more favorable exchange rate, resulting in higher earnings. We think this is why developed international equities have historically performed better in periods when their currencies were weakening, compared to periods when they were strengthening.6 Even though a stronger U.S. dollar and weaker euro or yen might help the profits of European or Japanese companies, the dollar strength can drag down the total returns of U.S. investors who do not hedge their international equity exposure. For this, we encourage investors to consider Japanese and European multinational companies, where we see some of the strongest examples of U.S. dollar strength relative to these currencies.
• Domestic Small Caps: Typically, small-cap companies generate a majority of their sales domestically and are not as sensitive to movements in exchange rates as large caps. Also, domestic small caps are typically not impacted by foreign economic growth, which has been tepid compared to U.S. growth.
1Tony Sagami, “The Ticking Time Bomb of the Strong US Dollar,” Mauldin Economics, 10/28/14.
2Ibid.
3The Coca-Cola Company, Third Quarter and Year-to-Date 2014 Results, 10/21/14.
4Philip Morris International Inc., 2014 Third-Quarter Results, 10/16/14.
5The Procter & Gamble Company, Q1 2015 Earnings Release, 10/24/14.
6Sources: WisdomTree, Bloomberg, 12/31/69–09/30/14. Refers to the currencies and equities in the MSCI EAFE Index.
Important Risks Related to this Article
Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. Investments focused in Japan are increasing the impact of events and developments associated with the region, which can adversely affect performance.
