A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

ETFs and the Tax-Managed Index
Fund

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One of the advantages, noted above, of passive portfolio
management (that is, simply buying and holding an index
fund) is that such a strategy minimizes transactions costs as
well as taxes. Taxes are a crucially important financial
consideration, as two Stanford University economists, Joel
Dickson and John Shoven, have shown. Utilizing a sample of
sixty-two mutual funds with long-term records, they found
that, pre-tax, $1 invested in 1962 would have grown to
$21.89 in 1992. After paying taxes on income dividends and
capital gains distributions, however, that same $1 invested in
mutual funds by a high-income investor would have grown to
only $9.87.
To a considerable extent, index mutual funds help solve the
tax problem. Because they do not trade from security to
security, they tend to avoid capital gains taxes. Nevertheless,
even index funds do realize some capital gains that are taxable
to the holders. These gains generally arise involuntarily, either
because of a buyout of one of the companies in the index, or
because sales are forced on the mutual fund. The latter occurs
when mutual-fund shareholders decide on balance to redeem
their shares and the fund must sell securities to raise cash.
Thus, even regular index funds are not a perfect solution for

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the problem of minimizing tax liabilities.
Exchange-traded index funds (ETFs) such as “spiders” (an
S&P 500 Fund) and “vipers” (a Total Stock Market fund) can
be more tax-efficient than regular index funds because they are
able to make “in-kind” redemptions. In-kind redemptions
proceed by delivering low-cost shares against redemption
requests. This is not a taxable transaction for the fund, so
there is no realization of gain that must be distributed to the
fund’s other shareholders. Moreover, the redeeming ETF
shareholder pays taxes based on his or her original cost of the
shares—not the fund’s basis in the basket of stocks that is
delivered. ETFs also happen to have rock-bottom expenses,
even lower than those of equivalent mutual funds. A wide
variety of ETFs are available not only for U.S. stocks but for
international ones as well. ETFs are an excellent vehicle for
the investment of lump sums that are to be invested in index
funds.
ETFs require the payment of transactions costs, however,
including brokerage fees
*
and bid-asked spreads. No-load
index mutual funds will better serve investors who will be
accumulating index shares over time in small amounts. I
suggest that you avoid the temptation to buy or sell ETFs at

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any hour of the day and to buy such funds on margin. I agree
with John Bogle, founder of the Vanguard Group, who says,
“Investors cut their own throats when they trade ETFs.” If
you are so tempted, follow the practice of Little Miss Muffet
and run far away from the spiders and their siblings.
In the table below, I list the ETFs that can be used to build
your portfolio. Note that for investors who want to make
their stock buying as easy as possible, there are Total World
Index funds that provide total international diversification
with one-stop shopping.