Last month, PIMCO co-founder and financial manager Bill Gross made industry headlines when he announced his departure from the company. Gross had founded the firm in 1971, and grew the PIMCO Total Return Fund to the world’s largest bond fund.
While we are not going to comment on his departure, his leaving the fund does highlight one very important area to consider for any investor: Taxes.
One article called his leaving—and the resulting fund redemptions—a “tax bomb.” Let’s take a look at why, and three strategies you should employ to minimize your taxes.
1. Use ETFs instead of mutual funds
As we saw above with the PIMCO Total Return Fund, when any investor in a mutual fund wants to redeem (sell) their shares, the fund may have to raise cash by selling some of the funds holdings. This event potentially triggers a capital gain, which is passed on pro rata to all holders of the fund.
Exchange-Traded Funds (or ETFs), on the other hand, are structured in such a way as to trigger fewer taxable events for the owner than mutual funds. In contrast, when an ETF’s owner wishes to sell their holdings, this is handled through an ETF creation / redemption process. A pool of securities—representing the holdings of one investor—is sold, and this taxable event only impacts the owner selling their shares (not the rest of the investors in the fund).
In other words, in a mutual fund, your tax bill can be impacted by the behavior of all the other owners of the fund—whereas with an ETF it is impacted only by the timing of your own buy and sell decisions.
2. Minimize turnover
Another way to mitigate tax responsibility is to minimize turnover within your funds. Turnover is a measure of trading frequency, and high turnover results in increased exposure to taxable events. Because most actively managed funds have a higher turnover than a comparable index fund, they typically bring a higher tax liability.
To find a fund’s turnover, simply go to Morningstar.com and enter the fund’s ticker. For example, the aforementioned PIMCO Total Return Fund (PTTRX) has an annual turnover of 227%—compare that to 73% for the Vanguard Total Bond Market Index Fund (VBMFX). On the Equity side, the $11 billion JPMorgan US Large Cap Core Fund (JLCAX) has an annual turnover of 90%—whereas the Vanguard 500 Index Fund (VFINX) clocks in at only 3%.
In the 2014 article titled “The Arithmetic of ’All-In’ Investment Expense,” founder and retired CEO of The Vanguard Group John Bogle estimated the tax advantage of index funds to be 0.45% annually over actively managed mutual funds. On a $2 million portfolio, this could result in $9,000 lower taxes each and every year.
3. Strategically Locate Your Assets
Even once you consider ETFs over mutual funds, and attempt to minimize the turnover within your funds—chances are, there is still a tax difference between the assets you hold. For example, due to their interest income, bond funds are less tax efficient than equity funds (this is true whether it’s an index or active fund). Also most alternative investments, by nature of the strategies they pursue, are less tax-efficient than other allocations.
Studies show that you can reduce your tax bill by holding the investments with the highest expected tax impact in your tax-deferred accounts (such as IRAs and 401k’s). The chart below depicts how assets classes that are less tax-efficient (in the lower right) should be located in tax-deferred accounts, while the more tax-efficient asset classes (in the upper left) should generally be placed in taxable accounts.
On average, the savings from tax-efficient asset location can be 0.20% – 0.75% per year. On a $2 million portfolio, this can result in tax savings of $4,000 – $15,000 annually.
At Cordant, we’re proponents of paying attention to the things you can control. And as such, taxes should be an important consideration in any investment decision.
The strategies above are best approached through a process we call Investment Integration. Because multiple account types (401k, IRA, taxable accounts) have different tax treatment and restrictions, it’s essential to look at your accounts holistically and through integration (all accounts managed as one cohesive portfolio). In this way, you can use each account in the best way to capture advantages and minimize taxes.
 Jaconetti, Colleen M. (2007) “Asset Location for Taxable Investors” and Gobind Daryanani, Ph.D., CFP®, and Chris Cordaro, CFP® (2005). “Asset Location: A Generic Framework for Maximizing After-Tax Wealth” Journal of Financial Planning 2005.
To learn more about how to mitigate taxes in your portfolio, give us a call at (503) 621 – 9207.
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