Director of ETF Capital Markets Will Creedon discusses how investment professionals are preparing for year-end tax planning and how ETF tax efficiency can help make their jobs easier. The 2020 market volatility has created tax-loss harvesting opportunities that haven’t been seen in several years, he tell host John Bryson. Will also provides insight on which asset classes might be ripe for tax harvesting, how the U.S. tax code may change after the election, and where to learn more about smart tax strategies. To learn more about using ETFs for tax-loss harvesting in volatile markets, explore this Viewpoint: https://www.jhinvestments.com/viewpoints/etfs/using-market-volatility-for-tax-loss-harvesting-with-etfs
John Bryson:
Hello, everyone, and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consulting at John Hancock Investment Management. As always, the goal of this podcast is to help investment professionals deliver better outcomes for their clients and their practice. Topics we'll typically address include advisor business-building ideas, capital market updates, the latest trends in portfolio construction, and investment insight from our veteran portfolio managers across our global network. Today, we're going to focus on an important topic that's relevant to all investors—specifically this time of year—and that's taxes. I'm joined today by Will Creedon, director of ETF capital markets at John Hancock Investment Management. Will spent the majority of his career in trading and portfolio management responsibilities, focused on equities, derivatives, and FX strategies, for several hedge funds and asset management firms around the world. Will, welcome to the call today.
Will Creedon:
Thanks, John. Thanks so much for having me. Looking forward to it.
John Bryson:
So, Will, we've talked a lot in the past, you and I, about ETFs, and we hear a lot in the marketplace that they're more tax efficient than mutual funds. Can you tell us why they are?
Will Creedon:
Sure. As you mentioned, it's certainly more of a topic of conversation this time of year, as advisors prepare for the capital gains season, but essentially the ETF is differentiated from the mutual fund in the way that it processes its cash flows. The traditional mutual fund is one where the shareholder, with their subscriptions or redemptions, essentially provide cash directly to the mutual fund. And when the mutual fund takes in investor cash, the portfolio managers have to go out and buy the securities in cash, and perhaps most important for our conversation around taxes today, when investors want to redeem shares of their mutual fund, the portfolio manager needs to sell securities to raise cash in the fund and then send that cash out to the redeeming investor. So one of the illustrations we try to make for the efficiency of an ETF over a mutual fund, first and foremost, is that mutual funds process subscriptions and redemptions in cash.
Will Creedon:
When a fund is selling securities to raise cash, that essentially creates capital gain and tax consequences for every shareholder in the fund. Now, the way that the ETF is advantaged in this scenario is that when an investor goes to buy or sell shares of the ETF, they go to the stock exchange to make that transaction, hence exchange-traded fund, and the way that the ETF is benefiting from a tax perspective is that when an ETF wants to process a subscription, that process is basically disintermediated by a broker or, in ETF world, we call them authorized participants, where the fund puts it on the brokers on the exchange to deliver securities in kind to the ETF, rather than cash. And most importantly, on a redeem, the ETF, when an investor wants to redeem fund shares, they can sell their shares on the exchange and that broker redeems fund shares back to us, the ETF.
Will Creedon:
But the secret sauce is that the ETF is able to send shares of the securities in the fund out in an in-kind fashion. And so the portfolio manager of an ETF is not selling stocks to raise cash—which is a taxable event—they are simply sending stocks out of the fund in kind. And so the ETF subscription and redemption process, or creation redemption process, is one of in-kind security transfers, which are nontaxable events. So the way that we always try to simplify it for advisors is that traditional mutual funds process redemptions in cash, which is taxable; ETFs process redemptions in kind, which is nontaxable
John Bryson:
Got it. In cash versus in kind is the key concept we want people to understand. Now, understanding the impact of taxes on your investments is always important, but we don't normally talk about it year round. We talk about it in the fall, and we're in the middle of October right now. Why are we focused on it right now?
Will Creedon:
I'd say there's three reasons why we think investors should be focused on tax management really this year, more than any other year, really in recent memory. To your point, John, it's always a part of practice management for advisors in the September, October, November, December period, as we head into calendar year end. But one of the reasons we think it's so important this year is, again, three things. One, with the market being as volatile as it's been due to the coronavirus pandemic, it's presented volatility and presented actual tax-loss harvesting candidates, or opportunities, for advisors to look at, which perhaps they haven't seen within their practice in four, five, seven, ten years. So we think it's opportune at this point to try and take advantage where possible of the COVID-driven volatility to tax-loss harvest. That's the first idea.
Will Creedon:
Second idea as to why it's so important is, as you said, we're in mid-October where it's some 13, 14, 15 days away from the U.S. presidential election, and with that is going to bring massive uncertainty from an investor and advisor standpoint with respect to future tax policy. So, no one can tell you exactly what the future tax policies are going to be with either administration due to the results of the election. So our comments to advisors are control what you can control right now and manage taxes as efficiently as possible within your client portfolios right now, because you just don't know what tomorrow's going to bring with respect to tax policy from the White House. I think third, and probably the most ongoing for the foreseeable future at least, is the macro economic environment that we're in currently. And John, your team at John Hancock, I believe envisions this being for the foreseeable future.
Will Creedon:
Let's call it for the next year or so. But I think that is one of extremely low interest rates and extremely accommodative government and federal reserve policy where the search for yield and, really, the search for income, is going to be extremely difficult for advisors and their clients. And so the point we would make is that tax management, and this concept of tax alpha, is more important now than ever because clients are going to be clamoring for every basis point they can get, or every dollar they can get, with respect to performance alpha, tax alpha, income, and really a lower tax bill. So all those things we believe to be extremely important this year, perhaps more so than any other in recent memory.
John Bryson:
Yeah, it makes sense. As we're in this low rate environment, any alpha you can get, whether it's a tax advantage alpha or just wise investment approaches, you take what you can get. Now, if I'm an investment professional and I'm looking at my client portfolios, where should I start to look at where I can maybe generate some of this tax alpha or some tax savings for my clients? And how do I introduce this concept to my clients without them feeling like I'm churning the account and simply looking to make a trade?
Will Creedon:
Yeah, it's a question we get a lot from the advisor community. Again, a lot of these concepts may be more familiar to some advisors than others, but, again, with the bull market that we were in prior to the COVID period, and now the volatility that we've seen, but we're back toward highs, I think the areas that can often get lost in the shuffle are areas of the clients’ portfolio that maybe haven't recovered as well in this calendar year as, say, the U.S. large-cap equity markets, as benchmarked by the, say, S&P 500 Index. If I'm an advisor, and I'm trying to introduce tax alpha to my clients, I would recommend looking in pockets of their portfolio—areas such as small-cap equities, deep value equities, emerging-market equities, perhaps. All of these sub-asset classes really haven't seen the recovery to historical highs that we've seen in large-cap-growthier areas of the market.
Will Creedon:
So you can introduce those smaller, perhaps less allocated to asset classes, where you can bring to your clients the idea of harvesting a loss and presenting that as a tax alpha opportunity by lowering their potential tax bill for this year, and when you talk about the concept of churning, you can always introduce to them that realizing a tax loss today, isn't something that has to be used in its maximum form this year. It can be carried forward into future tax years through the concept of a tax-loss carry forward. So, again, some concepts that some advisors would do well by digging a little bit further into that they can combat perhaps that client or household fear of churning by introducing not only the tax-loss and tax alpha concepts, but perhaps the tax-loss carry forward concept that would make this more of a longer-term value add, rather than illustrating a risk of churning in the short term.
John Bryson:
So, let's say I'm on board. I'm a financial professional, and I appreciate the benefits that ETFs bring in terms of tax efficiency, but I've got some of my favorite mutual fund managers that I believe in, in the long term. How should I think about building these options into my process as an advisor?
Will Creedon:
I think one of the things we often say is that the ETF wrapper isn't a panacea to tax management, right? It's a useful tool, but as you said, most the clients that we deal with believe in broad diversification across managers and diversification across wrappers. They use mutual funds and ETFs. So when you're talking about tax management or tax-loss harvesting with respect to how I would implement it into my practice, we often talk to advisors and illustrate to them how you not only need to focus on the qualified money in your practice.
John Bryson:
So Will, if I'm an investment professional and I've bought in and understand the tax benefits of using ETFs and how they can be more tax efficient than mutual funds, but I still have some of my favorite mutual funds, I believe in their process and strategy, and want to use them in a portfolio, how should I think about building both into my process?
Will Creedon:
I think that goes back to some of the earlier comments we made about this low interest-rate environment, perhaps this low expected return environment where every basis point counts, we still believe in an advisor’s ability to go out there and find quality managers that can help them realize alpha and outperform. So the way that we've been talking with our advisors about introducing ETFs, or using more ETFs in their practice, are along the lines of things like your active risk budget, or your active cost budget. If you're allocating to active managers in asset classes where you think there's more alpha to be had, let's say small-cap equities or international or emerging-market equities.
Will Creedon:
We think the ETF can be simply a tool that the advisor uses to manage taxes efficiently—especially at this time of year—but doesn't need to abandon a quality active manager for simply a passive product. We think knowing how to swap an ETF for a compelling mutual fund for a shorter period of time, to help manage taxes, is still something that the advisor can use in a systematic way within their practice, and, after understanding the wash sale rule, going back into that active manager a month or so into the future to still try to stick to their process of picking good managers and really trying to realize alpha for their clients over the longer term.
John Bryson:
If an advisor does want to work on a better outcome for their clients, what are some of the tools that they can look at to help them with this process?
Will Creedon:
A lot of the tools that we had been discussing with advisors, a lot of them use them broadly already, but we perhaps introduce the more tax management-focus aspects of them. But areas as simple as morningstar.com, most of the advisor community use Morningstar in some capacity, familiarizing yourself with the tax cost ratio concept and tools within morningstar.com is always a good place to start. See what kind of effect taxes have had on a particular manager historically, and try to understand how that will affect your expectation of that manager providing alpha into the future.
Will Creedon:
And the concept we just talked about of swapping an ETF or another mutual fund for a particular manager to save on taxes, there are tools out there from etf.com or etflogic.com, all free services that are non-subscription based, available to the public, where you can do fun compares, with respect to holdings comparisons, exposure and risk comparisons, where the advisor can enter some of their holdings and then evaluate some potential ETF swap ideas that will help best fit their asset allocation and their risk/return expectations as they go through this tax management process. And a shameless plug for you and your group, John, you guys always do great work from an investment consulting standpoint.
Will Creedon:
A lot of the asset managers that our advisors deal with, John Hancock Investment Management being one, but several others as well, will offer the advisor services around asset allocation consulting, investment consulting in general, where tax management and capital gain management can be introduced into that process. Those are specific tools that we've had some pretty substantial conversations with advisors over the last couple of weeks and months that are simply just starting points. We think the advisor, hopefully, will be able to dig in, realize some questions of their own, and folks like us in the John Hancock Investment Management ETF desk, or your group in investment consulting, are always there to help the advisory community.
John Bryson:
Will, thanks so much for sharing your insight. We appreciate how important it is to pay attention to the tax impact on investment outcomes, and the information you shared today would certainly help our audience. Folks, if you want to hear more, please subscribe to the Portfolio Intelligence podcast on iTunes, or visit our website at jhinvestments.com to read our viewpoints on macro trends, portfolio construction techniques, business-building ideas, and much more. Thanks for listening to our show.
Disclosure:
Alpha measures the difference between an actively managed funds return and that of its benchmark index. An alpha of three, for example, indicates the fund's performance was 3% better than that of the benchmark or expected return, over a specified period of time. ETF shares are bought and sold through exchange trading at market price, not NAV, and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV, in the secondary market. Brokerage commissions will reduce returns. A commission is charged on every trade. It is important to note that there are material differences between investing in an ETF, versus a mutual fund. ETF trades on the major stock exchanges at any time during the day, prices fluctuate throughout the day like stocks. ETFs generally have lower operating expenses. No investment minimums, are tax efficient, have no sales loads, and have brokerage commissions.
Mutual funds trade at the closing NAV when shares are priced once a day after the markets close. Operating expenses may vary. Most mutual funds have investment minimums, and are less tax efficient than ETFs. Many mutual funds have sales charges, and they have no brokerage commissions. This material does not constitute tax, legal, investing, or accounting advice, and is for informational purposes only, and is not meant as investment advice. Please consult your tax or financial advisor before making any investment decisions. John Hancock's ETFs are distributed by Foreside Fund Services, LLC in the United States, and are sub-advised by Dimensional Funders LP in all markets. Foreside is not affiliated with John Hancock Investment Management Distributors, LLC, or Dimensional Fund Advisors LP.
This podcast is being brought to you by John Hancock Investment Management Distributors, LLC, member FINRA,SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and other conditions warrant and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment strategy discussed will be successful or achieve any particular level of results. Any economic or market performance information is historical and is not indicative of future results, and no forecasts are guaranteed. Investing involves risks, including the potential loss of principal.