Typically, tax-efficient stock funds buy and hold stocks for the long term. As a result, they do not distribute capital gains at the end of the year. They also avoid high-dividend yielding stocks to limit taxable income.
A tax-efficient stock fund may use some or all of the following strategies:
- “Indexing” is when an investor invests in index funds that buy and hold a basket of stocks tied to a specific benchmark, such as the S & P 500. Index funds are tax-efficient because their trading decisions are relatively predictable. As shareholder money flows in, an index fund buys stocks to track its benchmark index and the fund sells stocks as investors redeem shares.
- Investing in low-portfolio turnover stock funds can increase tax efficiency. These funds typically invest in undervalued stocks and hold on to them for at least five years.
- “Tax-wise accounting” is a tax friendly technique used by most tax-efficient fund managers. When a stock is sold, a tax-efficient manager earmarks the highest-cost shares for first sale. This course of action either minimizes the gain or increases the loss realized on the stock. Highest-In First-Out, HIFO, increases after-tax returns while posing no disadvantage to shareholders in tax-deferred accounts.
- “Harvesting” is a procedure that involves deliberately selling securities on which a portfolio has a loss. That loss can then be used to offset gains on other securities now, or in the future.
Note: Exchange Traded Funds (ETFs) are index-based equity instruments that represent ownership in either a fund or a unit investment trust and give investors the opportunity to buy and sell shares of an entire stock portfolio as a single security. They have low expense ratios, are simple to use and explain, and are more tax-efficient than index funds. ETFs are not subject to shareholder redemptions so they don’t have to sell off their holdings and realize gains.