Portfolio Turnover and Pooled Fund Tax Efficiency

There are several steps investors can take to try to reduce their tax burden on top of deciding what assets to hold – including thinking about a pooled investment’s portfolio turnover ratio or level of trading activity. 

Volume of trades 

The way a pooled vehicle is managed and traded can have a significant impact on taxes. Anything with a high volume of trades could have higher taxes accrue on account of sell transactions occurring at a profit, which crystallizes those gains and creates a tax liability. Unfavourable trades lead to losses that can be used to offset gains

When a fund follows a passive strategy, by definition there will be limited trades — these only happen when the index composition changes and the fund manager needs to trade to match changes in the underlying index. 

Actively managed investments will have more transactions than passive, but trading activity varies widely across active vehicles. Investors can choose to invest in funds that match their specific needs and tax concerns by considering trading activity when evaluating their fund options. 

Other portfolio managers might use a more frequent trading approach, most notably with growth-focused, tactical or niche funds. In these instances, investors will need to carefully consider the potential rewards from these more aggressive strategies versus the likelihood of less favourable tax consequences. 

Portfolio turnover 

There is a useful metric for mutual funds and ETFs that provides investors with an indication of the trading volume in that vehicle: portfolio turnover. 

The portfolio turnover ratio is the rate at which assets in a fund are bought and sold by the portfolio manager. It’s expressed as a ratio that indicates the percentage change of the assets in a fund (typically) over a one-year period. 

In actively and passively managed funds, every sale is a potential taxable event for its investors, unless the assets are held in non-taxable accounts

Think about those tax slips you get for mutual fund distributions. This is precisely what can trigger those capital gains, which must be distributed to investors at least annually — and why investors who own heavily traded mutual funds or ETFs would do well to hold them inside tax-sheltered accounts, as much as possible. 

Portfolio turnover isn’t necessarily a bad thing, but tax surprises can be most unpleasant. So, investors should do their research before making a decision on which mutual funds or ETFs are right for them and their situation.

3 months ago