By Keith Poniewaz, Thun Financial Advisors Research, copyright 2016
Introduction: ETFs and the Expat Investor
Increasingly, Americans abroad are being locked out of financial services: U.S. mutual fund providers are restricting fund access and U.S. brokers are closing their accounts. The result is often frustration and confusion for those affected. However, the disruption can often become an opportunity for expats to review their investment strategies and advisor relationships in light of the broader changes taking place with respect to cross-border taxation and compliance (see “Why U.S. Accounts of Americans Abroad Are Being Closed”).
This new environment may often seem overwhelmingly complex. However, financial innovations such as Exchange Traded Funds (ETFs) can facilitate implementation of a superior investment approach than was traditionally available to expat investors. As described below, ETFs provide cost, tax and diversification advantages, while solving planning and compliance issues unique to expats.
What is an ETF?
An ETF is an “Exchange Traded Fund” and is similar to a mutual fund: essentially it allows the investor to hold a diversified selection of stocks or bonds in a single investment. However, whereas mutual funds price once a day, ETFs trade on an exchange and are continuously priced and repriced throughout the day. Generally, an ETF’s holdings (like an index fund’s) are tied to the composition of an index such as the S&P 500 Index (U.S. large capitalization stocks), the MSCI Europe Index (European stocks) or the Barclays Aggregate Bond Index (U.S. bonds). Most mutual funds, in contrast, hold securities selected by fund managers. For this reason and others, the ETF structure provides many efficiencies compared to mutual funds.
The first of these is cost efficiency. Mutual funds are generally managed by teams of highly compensated fund managers with responsibility for picking investments. ETFs, in contrast, mimic the holdings of their corresponding index without employing an expensive management team. Furthermore, mutual funds tend to turnover their holdings frequently, incurring substantial trading costs. ETFs are generally much more stable as the underlying index changes infrequently. Consequently, ETFs have lower turnover and significantly lower trading expenses. Based on a research paper by Edelen, Evans and Kadlec cited in Forbes, management and trading expenses consume 2.4% of the average mutual fund value annually. Over time, these high fees exert a huge drag on mutual fund performance. In contrast, the typical ETF has management fees of between 0.05% and 0.4% annually. The net result is that ETFs outperform traditional mutual funds over time.
The typical mutual fund will, during the course of the year, make several types of distributions—short term capital gains, long term capital gains and dividends or payments from the underlying holdings. Because mutual fund active management strategies tend to result in heavy trading and constant turnover within the funds’ portfolios, capital gains are constantly being realized rather than accumulated and deferred. Due to the legal and tax structure of mutual funds, these realized gains must be passed through to the underlying shareholders annually. The result is frequent taxable distributions and fewer deferred gains for the investor. This tax inefficiency is compounded for U.S. expats if they live in local jurisdictions with high tax rates.
ETFs generally avoid the tax inefficiencies of mutual funds described above. Because they have very little annual turnover, an ETF’s taxable distributions are generally limited to dividends and interest. Capital gains are not realized and the capital gains tax is deferred. As a result, the investor, not the fund manager, chooses the timing of the realization of capital gains. This provides the individual investor flexibility to manage her tax liabilities effectively.
Furthermore, an ETF portfolio lends itself to effective tax loss selling. In a portfolio holding single-asset class ETFs, tax loss selling opportunities arise through the normal variation of asset class returns. Gains and losses are not cancelled out as in multi-asset class mutual funds. These characteristics make ETFs more tax efficient and can result in substantially increased after-tax wealth accumulation.
Global Tax Efficiency
Beyond the ability to control when capital gains are realized, ETFs often escape common cross-border investment traps encountered by Americans around the world. For example, in certain countries, U.S. mutual funds will be subject to punitive taxation as off-shore or “non-transparent” investments. In contrast, ETFs may be afforded optimal tax treatment because they are traded on an exchange. An additional example is the UK, where U.S. investors must avoid holding so-called “non-reporting” funds. Unfortunately, few U.S. funds qualify as reporting funds. However, several ETFs are reporting funds and the best U.S. listed UK “reporting funds” are all ETFs (see Thun’s article “Americans in the UK Need to Avoid this Catch-22 Investment Trap”).
ETFs and Efficient Expat Portfolios
Financial advisors have stressed diversification to investors for many years (see Thun Financial’s “Tracking the Benefit of Diversification through the Lost Decade of 2000-2009”). However, many portfolios are not properly balanced: they hold too much cash, too much stock (or too many bonds), or too much in U.S. domestic securites ETFs take a giant step towards providing diversification by providing low-cost access to all of these fund categories through U.S. markets. In addition to domestic stocks and bonds, ETFs provide access to international stocks, bonds and alternative investments, including global real estate and commodities.
Achieving global diversification is also important to expats for planning purposes. American expats frequently change jobs and countries of residence. Therefore, they are exposed to a variety of countries and currencies. A fundamental principle of cross-border currency planning is that some money for future expenses should be held in the same currency as those expenses (see Thun Research’s “Managing Currency Risks as an American Abroad: In What Currency Should I Save and Invest”). However, because many Americans are unsure of where they will be in several years, they require a globally diversified portfolio with exposure to many currencies. The wide variety of ETFs allow investors to efficiently and precisely diversify their portfolio in terms of geography and currency.
Americans with more fixed long term plans should also incorporate currency planning into their investment strategy. For instance, Americans who plan to stay abroad after they have finished working will want to hold some funds in the currency of their country of retirement. Even Americans who plan to return to the United States may still have particular currency-related estate planning issues: for example, children who’ve stayed in the adopted country. In these situations, mutual funds can fail to deliver the necessary currency exposure: frequently, mutual fund managers will perform currency hedging, or betting on currency fluctuations, to increase returns. This currency hedging eliminates the very currency exposure the American Expat requires for financial planning purposes. In contrast, an unhedged ETF tracking a foreign country or region’s index provides and maintains the proper currency exposure for the American abroad. In sum, ETFs solve the geographic and currency diversification problems of American expats in a way that facilitates long-term financial planning.
Like many things about living abroad, changing one’s investment strategy can be an opportunity disguised as a challenge (provided Americans avoid the major mistakes made by expats abroad). The structure and efficiency of ETFs allow them to provide solutions to common tax and compliance challenges faced by Americans abroad. Most importantly, ETFs are only one strategic element of financial planning and investment management, and should be incorporated alongside holistic financial planning (long-term wealth, estate and tax planning) to fully convert the initial challenges into an opportunity to create a secure financial future anywhere in the world.
This article does not constitute legal or tax advice, nor a solicitation to obtain clients to provide legal or tax advice. Thun Financial Advisors L.L.C. does not render legal or tax advice to its clients or the public. Please consult a licensed attorney or tax preparer regarding the suitability of any strategy, or the applicability of any rule or law, referenced herein, to your individual legal or financial circumstances.