It may be too late for this year, but these five exchange-traded funds earn top marks from analysts and may help soften the tax bite for 2007
The recent global stock sell-off might be investors' biggest worry these days, but it's likely not their only one (see BusinessWeek.com, 3/1/07, "What the Market Is Telling Us"). With this tax season's Apr. 17 (delayed due to a Sunday and Emancipation Day) deadline fast approaching, many taxpayers may also be turning with fearful eyes toward the IRS. While it's probably too late for most of us to reduce any 2006 tax pain related to our investment holdings, a hard look at this year's return can help you assess your portfolio's tax exposure and plan changes to improve things for coming years.
Exchange-traded funds, or ETFs, have long been heralded for their tax-efficiency (see BusinessWeek.com, 1/18/07, "Going Global with ETFs"). Unlike traditional mutual funds, ETFs don't have to sell shares of stocks and possibly incur taxable capital gains when shareholders reduce their stake in a fund. Like index funds, ETFs typically have low portfolio turnover, also cutting down on potential tax hurt.
But new products are hitting the market almost every week, and not all ETFs are created equal. This Five for the Money looks at five ETFs rated in the top of their class for consistent return and tax efficiency by fund tracker Lipper. As part of a well-diversified portfolio, these funds could deliver stable long-term gains and help fend off the tax collector, too.
1. iShares MSCI Austria Index (EWO)
The hills are alive with the sound of the tax man biting into your returns. But a jaunt to Austria, courtesy of the iShares MSCI Austria Index ETF, might result in a sweeter refrain. This ETF has posted average annualized returns of 36.02% in the five years ended Mar. 13, compared to 15.17% for the MSCI EAFE index. The fund carries a low 0.54% expense ratio and lost only an average annualized 0.42 percentage points of its returns to tax costs over the past five years, according to Morningstar (MORN) data.
IShares MSCI Austria Index has posted stunning returns at times, but it probably shouldn't be a big holding for most investors. "That would be for somebody who was either familiar with the European region or felt that they needed to have additional exposure to Austrian equities," explains Lipper senior research analyst Jeff Tjornehoj.
2. iShares Russell 2000 Value Index (IWN)
A multi-year rally for small-cap value stocks—equities of small companies seen trading at lower prices relative to their fundamentals—has lifted many boats. The iShares Russell 2000 Value Index ETF is no exception. For a 0.25% expense ratio, the fund has racked up five-year average annualized returns of 13.01%, vs. 5.58% for the broader Standard & Poor's 500 index.
Like other ETFs listed here, iShares Russell 2000 Value Index also earns Lipper's top score for tax-efficiency. On an average annualized basis, tax costs cut only 0.54 percentage points out of the fund's impressive returns over the past five years. However, investors may want to consider how long small-cap value's winning streak can continue before buying shares (see BusinessWeek.com, 1/3/07, "Style Wars: Growth or Value in '07?").
"It's not surprising to see value indexes showing up on this list," says Lipper's Tjornehoj. "They've had a very good run over the past three years, and they've been able to do that despite the fact that so many value stocks are oftentimes regarded as spinning off too much income for some investors."
3. Vanguard Small Cap Value ETF (VBR)
A like-minded offering from a long-time stalwart of low-cost, passive investing is the Vanguard Small Cap Value ETF. This fund undercuts iShares Russell 200 Value Index with a cheap 0.12% expense ratio and tracks the MSCI U.S. Small Cap Value index, considered by some to be a better benchmark because of its more complex methodology.
Over the past three years, the Vanguard Small Cap Value ETF boasts average annualized returns of 13.62%, or 4.5 percentage points ahead of the S&P 500. Tax costs ate up an average 0.52 percentage points of those returns each year. Top holdings include Northeast Utilities (NU) and OfficeMax (OMX).
4. iShares Russell Midcap Value Index (IWS)
Value has been the name of the game for medium-sized companies' stocks, as well. True to its name, the iShares Russell Midcap Value Index ETF tracks the Russell Midcap Value index, which comprises the value-tilted stocks of the Russell Midcap index. The index is more heavily weighted to larger companies than are some other midcap benchmarks, according to Morningstar, likely helping this ETF generate such consistent returns.
iShares Russell Midcap Value Index has generated average annualized returns of 14.5% over the last five years, topping the S&P 500 by 9.01 percentage points. A modest 0.25% expense ratio and a low 0.66 tax cost ratio mean shareholders can enjoy nearly all of the returns.
5. Vanguard Value ETF (VTV)
Last but not least, the Vanguard Value ETF has built up a solid record of tax-efficient performance in the large-cap segment. The fund tracks the MSCI U.S. Prime Market Value index, made up of value-oriented stocks within a group of the country's 750 biggest companies. In the past three years, the ETF has posted average annualized gains of 13.24%, beating the S&P 500 by 4.12 percentage points.
Vanguard Value ETF can also lay claim to a meager 0.11% expense ratio. And tax costs? The IRS's average annualized hit to the fund's total return over the past three years has been 0.51 percentage points.
Of course, as frustrating as tax season can be, investors shouldn't judge a fund solely on tax efficiency. These ETFs have a track record of dependable returns to go with their tax-savvy advantages. At least that can help investors breathe a bit easier amid the stock market's ongoing gyrations.