What Is a Tax Managed Fund and Its Investment Strategies

A tax-managed fund is a type of investment fund that aims to minimize taxes while still providing competitive investment returns.

These funds use various strategies to achieve this goal, including tax-loss harvesting, where losses are offset against gains to minimize tax liabilities.

Tax-managed funds typically focus on long-term investing, rather than trying to time the market or make quick profits.

By managing taxes effectively, tax-managed funds can help investors keep more of their returns, rather than giving it all to the taxman.

Tax efficiency is a crucial aspect of investing, and tax-managed mutual funds are designed to minimize taxes on your investments. In fact, just 2.5% of ETFs distributed capital gains in 2023 compared to 31.5% of mutual funds.

Taxes can eat away at your investment portfolio, but investing in a tax-efficient manner can help reduce the tax bill and keep more of your investment returns. For example, on $1,000 of interest income earned, an investor would keep $536 with $464 to be paid in taxes.

Mutual funds can trigger taxes in three ways: interest income, dividend distributions, and capital gains distributions. Eligible Canadian dividends are taxed favourably, but US and foreign dividend income are taxed as other income.

Tax-managed mutual funds can make a big difference in minimizing taxes. They're designed to generate returns via fund price increases while minimizing annual capital gain distributions. In fact, they can eliminate the prospect of unexpected distributions, giving investors control over the tax year in which capital gains are reported.

The difference in capital gains distributions between ETFs and mutual funds is staggering - 2.5% of ETFs compared to 31.5% of mutual funds distributed capital gains in 2023. This is because ETFs use a tax-efficient, in-kind redemption process to meet shareholder redemptions, whereas mutual funds must sell securities to raise cash, creating a possible capital gains event for all shareholders.

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A tax-managed fund can invest in a variety of asset classes to diversify its portfolio, including shares, property, and fixed income.

Investing in a fund that focuses on tax management can help minimize tax liabilities, allowing you to keep more of your returns.

These funds can also invest in alternative assets, such as infrastructure and commodities, to spread risk and increase potential returns.

ETFs are generally more tax efficient than mutual funds. This is due to their tax-efficient, in-kind redemption process.

The in-kind redemption process allows ETFs to meet shareholder redemptions without selling securities, which can trigger capital gains. This reduces the number of capital gains distributions.

In contrast, mutual funds must sell securities to raise cash for redemptions, creating a capital gains event for all shareholders. This results in a significant difference in capital gains distributions between ETFs and mutual funds.

In 2023, just 2.5% of all ETFs distributed capital gains, while 31.5% of mutual funds did. This staggering difference highlights the tax efficiency of ETFs.

ETFs' ability to support secondary market transactions also reduces the number of primary market transactions needed for redemptions. This is especially true for small ETFs that cannot deliver all securities in-kind.

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Active equities are a growing option for investors looking to manage taxes. Russell Investments has been a leader in active tax management for over 35 years in the US, and they're now bringing their expertise to Canada.

Tax management for active strategies isn't as simple as it is with indexes. With direct indexing, tax losses are typically used to offset capital gains from other strategies in the portfolio.

One key difference in active strategy tax management is how tax losses are used. In active strategies, tax losses are first used to offset any capital gains the managers may incur from selling their winning picks.

Parametric, a direct-indexing provider, is expanding its capabilities to include actively managed equity strategies. They've announced an extension of their tax overlay to active managers, making tax management more mainstream.

Tax management for active strategies creates a tension between harvesting losses and preserving the manager's best ideas. This is because investors are paying managers to pick the best stocks, and selling a winning pick can dilute the manager's stock picks.

Parametric's new option takes a different approach to avoid this risk. They work with active managers to provide a list of substitute stocks to swap in as replacements, allowing managers to preserve their best ideas while still managing taxes.

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A tax-managed balanced fund is a type of investment that's 48% US Large Cap Stocks and 52% muni bonds. The expense ratio for this type of fund is 0.11%.

The tax-managed balanced fund follows the Russell 1000 index, which may not be the best choice for everyone. The bond portion of this fund is similar to the intermediate tax-exempt bond fund.

One of the key benefits of a tax-managed balanced fund is that it can help minimize tax losses, with a 0.95% loss to taxes over 10 years. In contrast, a regular balanced fund with a more aggressive asset allocation may lose 1.59% to taxes.

Here are some key statistics for a tax-managed balanced fund compared to a regular balanced fund:

While tax-managed balanced funds have some benefits, they may not be the best choice for everyone, especially those looking for a "one-stop shopping" type fund with international stocks.

Investing in a Total Stock Market fund can be a smart move, especially when compared to a combination of tax-managed funds. Total Stock Market saves 0.05% in expenses compared to the 0.09% expense of the TM combination.

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One key advantage of Total Stock Market is that it eliminates the need to rebalance between large-cap and small-cap funds, which can save you from realizing your own capital gains.

The expense comparison between the two options is clear: Total Stock Market has a lower expense ratio of 0.04% compared to the 0.09% of the TM combination.

Here's a breakdown of the costs in different tax brackets:

Keep in mind that these calculations are based on assumptions about taxes and dividends, and your actual tax cost may be higher depending on your individual circumstances.

A tax-managed fund is a smart way to invest, and one of the key strategies is year-round tax loss harvesting. This means that the fund's managers are always on the lookout for opportunities to sell securities that have lost value, which can help offset gains from other investments.

Russell Investments takes this approach to the next level by employing an internal overlay management team to coordinate trading activity across all the underlying money managers within each tax-managed mutual fund. This centralized trading desk helps minimize superficial losses by paying attention to holding periods.

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Tax-smart portfolio turnover is another important strategy used by tax-managed funds. This means that the fund's managers aim to minimize the number of trades they make, which can help reduce capital gains distributions. By doing so, they can help investors keep more of their earnings.

With total portfolio management, all the securities within each fund are held in a single custody account, where they are fully monitored and solely transacted by the overlay management team. This approach can help eliminate overlap and reduce administration and trading costs.

By coordinating trading activity and minimizing overlap, tax-managed funds can help reduce capital gains distributions and save investors money.

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ETFs backed by physical metals like gold and silver may be treated as collectibles for tax purposes, carrying a higher top federal long-term capital gains tax rate.

The structure of an ETF can significantly impact its tax implications. For example, commodity ETFs using futures contracts are often structured as limited partnerships, which can lead to the "60/40" rule.

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The "60/40" rule means 60% of the capital gain or loss will be treated as a long-term capital gain or loss, and 40% will be treated as a short-term capital gain or loss, regardless of the actual holding period.

Currency ETFs are sometimes structured as grantor trusts, which means all distributions and gains may be taxed as ordinary income.

Leveraged/inverse ETFs may have high turnover and use derivatives that may receive 60/40 tax treatment.

Here are some common ETF structures and their tax implications:

Taxation is a crucial aspect of investing, and tax-managed funds are designed to minimize tax liabilities. Tax efficiency refers to how well an investment minimizes an investor's taxes during the holding period, and ETFs typically generate low capital gains tax liabilities from distributions.

ETFs can have tax consequences, with distributions paid out monthly, quarterly, semiannually, or annually. These distributions come from multiple sources, including dividends, interest income, capital gains, and return of capital.

Dividends from ETFs can be taxed at favorable capital gains rates if they meet certain holding period criteria, but non-qualified dividends are taxed at ordinary income tax rates. Interest income from taxable bond ETFs is generally taxed at ordinary income tax rates.

Capital gains distributions from ETFs are taxed based on how gains and losses are generated and reported, with a portion attributable to long-term capital gains and short-term capital gains. Return of capital distributions are not immediately taxable and are not considered income or profits.

Mutual funds, on the other hand, can have taxes triggered in three ways: through interest income, dividend distributions, and capital gains distributions. Eligible Canadian dividends are taxed favorably, while US and foreign dividend income are taxed as other income.

Here's a summary of the tax implications of different types of distributions from ETFs and mutual funds:

Tax-managed funds, like TM Capital Appreciation, can offer tax savings by selecting stocks to reduce dividend yields and minimizing capital gains distributions. However, the tax savings may not cover the cost difference, especially at higher tax brackets.

A tax-managed fund can invest in a variety of assets to minimize tax liabilities.

There are several types of investments that a tax-managed fund may hold, including shares, property, and bonds.

Some tax-managed funds may also invest in a mix of Australian and international shares, which can provide diversification and potentially lower tax liabilities.

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Tax-Managed Small-Cap is a fund that tracks the S&P 600 index with 0.01% lower expenses and a comparable yield.

The advantage of Tax-Managed Small-Cap is more qualified dividends, but the difference has decreased since 2020, with only 5-7% more than the S&P 600 ETF and 2-3% more than the Small-Cap Index.

If you don't use ETFs, the Small-Cap Index has an expense ratio 0.03% less than Tax-Managed Small-Cap, which could give a slightly lower tax cost, but a higher cap range, so you need more of Small-Cap Index to get the same small-cap exposure.

Here's a comparison of Tax-Managed Small-Cap, the S&P 600 ETF, and the Small-Cap Index:

Tax-Managed Small-Cap has a higher expense ratio than the Small-Cap Index, but the difference is relatively small, and the fund's tax efficiency is still a consideration.

Fixed-Income investments can be a great way to diversify your portfolio, but they don't offer as many tax-management opportunities as equity investments.

On average, tax-management providers expect about half as much tax alpha opportunity from taxable-bond SMAs as they do equity SMAs.

Bonds of the same credit quality and duration tend to move in tandem, making it harder to find tax-loss harvesting opportunities.

In periods of rising interest rates, bond prices go down, creating some tax-loss opportunities, but this is rare in a falling interest rate environment.

Between large stock market selloffs, bonds can be very sleepy, except for the occasional credit downgrade or default.

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