ETFs for the long run

A reader tries to make sense of how to use ETFs and tax-managed funds.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: I'm considering investing in tax-managed funds and exchange traded funds (ETFs). But do I have to monitor these investments constantly or can I hold them for the long-term?

Also, how can I buy them? - Ko Wang, Fort Worth, Texas

Answer: Not only can you hold tax-managed funds and ETFs for the long-term, you should. That's the way you maximize their tax advantages. To appreciate why this is the case, however, you've first got to understand how these funds work.

Here's the skinny...

Most mutual fund managers trade the fund's stocks frequently in their search for gains. But whenever the fund "realizes" a profit, fund shareholders get a tax hit. So even if you haven't sold shares of your fund, you can end up owing taxes because of the trading your manager does. (Unless, of course, you hold the fund in a tax-advantaged account like a 401(k) or IRA.)

Managers of tax-managed funds employ a variety of tactics to avoid taxable distributions. They might trade less frequently. Or they might purposely sell lagging stocks for a loss to offset gains.

There are two advantages: One, you can postpone the tax bite for a long time by not selling your fund shares, which in effect boosts your long-term after-tax return. Two, by holding your fund shares more than a year before selling, you're taxed at the long-term capital gains tax rate of 15 percent versus the short-term rate of 35 percent.

ETFs are a different animal altogether, but they're similar to tax-managed funds in one key respect - they too tend to throw off fewer taxable distributions. In the case of ETFs, their tax-efficiency results from two features.

First, they're index funds (although some ETFs, admittedly, stretch the definition), which means they buy and hold the securities of a benchmark like the Standard & Poor's 500 or Russell 2000.

ETFs also have a unique way of creating and redeeming shares when investors are entering or exiting the fund, and that also boosts their tax-efficiency a bit.

The upshot of all this is that tax-managed funds and ETFs allow you to create your own little tax shelter of sorts. You invest your money, let it sit and most of the gains accumulate without the drag of taxes. The longer you postpone selling the bigger the tax benefit. So if you buy and sell these funds frequently, you're giving up much of their tax advantage.

I should add that just because you're holding tax-managed funds and ETFs for the long-term doesn't mean that you don't have to monitor them. You should keep an eye on them, but you certainly don't have to do it constantly. I'd say checking their returns vs. that of similar funds once a quarter is plenty enough monitoring. Actually, monitoring isn't much of an issue for the ETFs in that they're following an index. As long as they don't stray drastically from it, there's not a whole lot for you to worry about.

Tax-managed funds, however, are actively managed (although some use an indexing approach), so you want to check in to make sure the manager hasn't done anything to screw up the fund's performance. Again, though, checking their returns about once a quarter to make sure they're performing decently versus similar funds is attention enough.

As for buying these funds, you can easily come up with a list of tax-managed candidates by going to Morningstar's Web site and typing tax managed (with no quotes around the two words) into the Quotes box at the top of the page. Some of the funds that pop up are "load" funds - that is, you buy them through a broker or financial planner and pay a fee.

Others are "no load," which means you buy them directly from the fund company. If you're okay picking the funds on your own, stick to the no loads. Whichever route you go, try to stick to ones that have solid performance and low fees, as do the T. Rowe Price and Vanguard tax-managed funds.

For ETFs you might buy, I suggest you go to the ETF section of the Money 70, Money Magazine's elite list of recommended funds. Note that we tend to focus on ETFs that let you buy virtually the entire market or broad pieces of it (large-cap, midcap or small-cap stocks, for example). We've also thrown in a few ETFs that can help you diversify more broadly (commodities, natural resources, real estate, emerging markets).

What you won't find on the Money 70 are ETFs that focus on narrow slices of the market (agriculture, beverages) or ETFs that are gimmicky (Nanotechnology? Come on.). Or ones that strike me as bordering on speculation, like the new breed that use a variety of techniques that can magnify your gains (or losses). For more on what I consider reasonable ways to use ETFs, click here.

Remember, though, that since ETFs trade on an exchange, you must buy and sell through a broker and pay brokerage commissions. Unless you're investing large amounts of money (say, less than $10,000 or more) and holding the ETF a long time, those commissions can wipe out one of the other big advantages of ETFs, their low annual management fees. If you're investing smaller amounts, you can get the most important advantages of ETFs (indexing and low fees) by buying a good index fund (which, conveniently enough, you can find in the index fund section of the Money 70.

So by all means check out tax-managed funds, ETFs and, for that matter, regular old index funds. And while you don't have to monitor them constantly, you definitely want to keep tabs on them to see how they're doing. Most important, though, hold them for the long-term. Because that's how you'll get the biggest bang for your buck out of such funds.

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Next stop - Roth IRA

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Moving taxed funds from an IRA to a Roth IRA

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.