Exchange Traded Funds

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Exchange Traded Funds: An Investment Move You Need to Make…

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, November 24, 2008: Issue #891

With the stock market’s historic drop this year, some investors have fled to cash. Others are cautiously buying. Most, however, are sitting on their hands.

They shouldn’t be.

Even if you lack the cash – or the willpower – to buy into this market, there is still a very smart move you can make: switch.

Switch from your poor-performing, high-cost, tax-inefficient stock and bond mutual funds to index funds or exchange-traded funds (ETFs).

It’s a very smart move. Here’s why…

Why Choose Exchange Traded Funds Over Mutual Funds?

Compared to exchange traded funds, most mutual funds are a lousy deal, here’s why:

Each year more than three-quarters of them fail to match the performance of their benchmarks.

Many are loaded with front-end or back-end loads, 12b-1 fees, high management costs and other expenses.

Moreover, even when these actively managed funds fall sharply, they still often distribute annual capital gains to shareholders, in effect handing shareholders a paper loss and a tax bill at the same time.

Don’t stand for it. Now is your chance to fight back.

Switching to Exchange Traded Funds Will Save On Taxes

Switch from your underperforming mutual funds to index funds and exchange-traded funds – and save yourself thousands of dollars in taxes in the process.

The IRS allows you to take losses each year to fully offset any realized capital gains. And also allows you to take capital losses to offset up to $3,000 in earned income.

In a year as nasty as this one, of course, you probably don’t have too many realized capital gains to worry about.

You should make this switch anyway. The IRS allows you to carry forward your losses indefinitely to offset future capital gains.

As bleak as the outlook is today, there will be capital gains in your future and, eventually, the tax on them is going to be higher than it is now.

Aside from the thousands you’ll save in taxes (and expenses) in the years ahead by making this switch to exchange traded funds, there is an important psychological reason to do it.

When you get your statements in 2009 and beyond, instead of looking at a smorgasbord of losing positions you’ll be looking at winners. You may not end up buying at the very bottom – few do – but you will have bought a whole lot closer to it than you did originally.

Exchange Traded Funds – Turning Market Lemons Into Lemonade

So take the lemons the market has handed out so abundantly this year and turn them into lemonade with exchange traded funds. Here’s how:

Sell Your Losing	Replace It With:
Gold Stock Funds	Market Vectors Gold Miners ETF (NYSE: GDX)
U.S. Large-Cap Stock Funds	S&P 500 ETF (AMEX: SPY)
U.S. Small-Cap Stock Funds	Vanguard Small Cap ETF (NYSE: VB)
International Stock Funds	iShares MSCI EAFE (NYSE: EFA)
Corporate Bond Funds	Vanguard Total Bond Mkt ETF (NYSE: BND)
Junk Bond Funds	iShares High Yield ETF (NYSE: HYG)
Inflation-Adjusted Bond Funds	iShares Lehman TIPS (NYSE: TIP)
Emerging Market Stock Funds	iShares Emerging Mkts (NYSE: EEM)

Using Identical Exchange Traded Funds As Smart Tax Moves

If you’re already invested in exchange traded funds, incidentally, you can still make the same smart tax move by selling your losers and moving into virtually identical funds.

For example, you can take a loss in one S&P 500 Index Fund (AMEX: SPY) and replace it with, say, this S&P 500 Index Fund (AMEX: IVV). Even though these funds have the same benchmark and are virtually identical, they are different funds, so the IRS allows the switch.

(For a complete list of ETFs at Fidelity.com.)

However, you cannot sell a fund and buy back the exact same one and qualify for this deduction (unless you wait at least 30 days). If you do, you run afoul of the wash-sale rule.

Incidentally, if you own individual shares that are down but for which there is no logical replacement (think Apple or Berkshire Hathaway) and you don’t want to sell and risk that the stock will be substantially higher 30 days from now – always a possibility from these depressed levels – you can double down on your stocks now, then sell your higher-cost shares the last week of December. (You will, of course, be doubling down on your risk for the next 30 days.)

If you plan to do this, however, you need to do it by the end of the month. Once November ends, it will be too late to do it for the year.

Bear in mind, you cannot take tax losses in an IRA, 401(k) or other qualified retirement plan. But you should still consider making the switch to ETFs and index funds for the cost advantages and psychological benefits I’ve described.

Over the next few weeks, I’ll share still more ways for you to save thousands of dollars in taxes this year. Stay tuned …

Good investing,

Alex

Today’s Investment U Crib Sheet

Tax planning is something that should be done over the course of the year – not just right before tax time. However, it’s the fast approaching year-end deadline that makes the next month so critically important for tax purposes. The new administration is expected to make changes to taxes, but no one knows what for sure. That’s why David Fessler – our energy and infrastructure expert – has been looking at some of the companies and sectors expected to benefit the most from President-elect Obama.

In order for Obama to turn this economy around, he has to jumpstart one critical “economic fuel.” And if he takes a page from history, his choices could be profitable for investors. To find out more information about the seven companies that should benefit from Obama’s “New Deal,” check out Investment U Issue #883,Obama’s New “Economic Fuel”… and 7 Ways to Profit.

There’s another infrastructure need that Obama has already voiced his support for. In fact, he states in his website that he believes “America should lead the world” in broadband penetration. Which means 50% of the country is going to need massive upgrades. To get David’s seven companies that stand to gain, go to Investment U Issue #886, Broadband Penetration: 7 Ways to Profit From Our Biggest Infrastructure Need, for more information.

Alex Green showed us Municipal Bonds: The First “Obama Investment” in June – well before his decisive election victory. And now that he’s President-elect Obama, the benefits are even greater. But who doesn’t want a few good tax-free investments? To get more information on how to reduce your taxes, check out Investment U Issue #869, Municpal Bonds: A True Once-in-a-Lifetime Opportunity.

Professional tax advice is advisable for personal needs, but if you’re looking for basic information, the IRS website is the place to go. You can get tax forms, answers to basic questions and even more information on tax-exempt bonds.