The Investment Scientist

Tax Advantaged Investing

Posted on: June 18, 2021

Recently, Dimensional Fund Advisors (DFA,) a mutual fund company whose funds I use a lot for my clients, replaced its Tax-Advantaged US Core 2 Equity Fund DFTCX with an ETF DFAC. In this article, I will explain how a mutual fund can achieve tax-advantaged status, and I will further explain how it is even more advantageous to move to an EFT.

A mutual fund is simply a pooled investment vehicle. Many folks’ money is pooled together in the fund, and the fund manager invests it. As a fund investor, you may still hold the fund and therefore there is no realization of capital gains on the portfolio level. But on the fund level, there are still capital gains because of trading. These gains are passed down to each individual investor, and they must pay taxes on them. This is despite the fact that they have not sold the fund. 

A tax-aware fund manager can reduce this tax burden on the fund’s investors by trading less, especially by deferring the realization of gains. That’s why a fund’s turnover is an indicator of a fund’s hidden cost. The higher the turnover, the higher the transaction costs and tax burden. 

Over time, however, a tax-advantaged mutual fund will have so many unrealized gains in it that it could be forced to realize gains when some investors withdraw money. The realized gains will be distributed to all investors regardless of whether they withdraw money or not, resulting in earlier taxation of buy-and-hold investors. 

This is where an ETF can help. Unlike a mutual fund, an ETF does not distribute fund-level trading gains, thereby removing the early taxation issue. The mechanism they use to do that is a bit too elaborate for this short article. Suffice to say that an EFT is more tax-advantageous than an otherwise identical mutual fund. 

Why didn’t I move all mutual funds to EFTs then? Well, there is the issue of transaction costs, but the biggest issue is that nearly all of my clients have huge unrealized gains in their mutual fund positions. Selling these funds and buying identical ETFs (assuming they exist) would automatically result in capital gain realization and taxation. That’s why I have been extremely cautious.

Luckily, DFA is here to help. They will now replace some of their funds with identical ETFs. Since this is considered a securities exchange, it is not a taxable event, meaning there is no capital gain realization and taxation!

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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