Mutual funds don’t belong in taxable portfolios
For those of you traveling to Italy this year (jealous), here’s a trick: If you want a smart guess as to whether a gelato place is decent before committing, look at the color of the pistachio flavor.
If it’s bright green, the shop probably uses powdered flavors and dyes. If it’s a drab nutty brown, the shop probably uses fresh, whole ingredients — order away!
A similar at-first-sight heuristic is helpful for looking at taxable general investing accounts (i.e., not an IRA, 529, etc.). If I see mutual funds — as opposed to ETFs — in a taxable account, I’m a little suspicious of the client’s prior advisor. Now, there could be a great reason for the holding, like preserving the cost-basis of an earlier purchase that’s appreciated substantially. But it could also be a sign that the client’s prior advisor doesn’t follow new trends, uses old technology, or relies on revenue-share arrangements that may not be in the client’s best interests.
Why are ETFs so much more tax-efficient than mutual funds, even if the two wrappers are holding similar underlying investments? It’s a quirk of the tax code. Mutual fund managers have to sell securities to re-allocate assets. This means more frequent capital gains distributions for shareholders. ETFs work by using “creation units” — basically baskets of tens or hundreds of thousands of shares — which let brokers trade shares like Pokemon cards. Because they’re not actually selling the assets, there’s no capital gains distribution to create a taxable event.
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