Welcome to this week’s ETF Insider. Minimizing tax bills is a big driver of advisor interest in direct indexing within managed accounts. But a new Morningstar analysis shows how much clients can save by using tax-managed versions of model portfolios, which often are packed with low-cost ETFs, relative to traditional asset allocation portfolios. Tax-managed ETF models can help bring that value-add tax service to smaller accounts.

Helping clients navigate the noisy environmental, social and governance landscape is another top task for FAs these days. We’ll also take a look at some new ETFs seeking to bring sustainability into the gold market. It’s another example of trying to thread the needle between the business case for commodities and client concerns about supporting resource extraction.

Thanks, as always, for reading this newsletter. Reach out at any time with feedback: editorial@financialadvisoriq.com

Jackie Noblett, producer of ETF Insider at Financial Advisor IQ

Figuring out how to build wealth while minimizing what you fork over to Uncle Sam is one of the big reasons people hire financial advisors. Recognizing this, many FAs recognize have focused on tax management as a value-added service.

This focus is one of the reasons advisors have grown to love ETFs: the in-kind creation and redemption process makes the products far more tax efficient than traditional active mutual funds, which often pay out taxable gains irrespective of whether you’ve sold shares.

But in recent years, advisors have been kicking the tires on separately managed accounts and related technology that allow them to build a customized exposure to particular asset classes and rebalance allocations to match a client’s specific tax needs. This is the rise of direct indexing.

Click on the image to get a brief refresher on the mechanics of direct indexing.

Direct indexing can be great for large accounts with complicated tax situations. But if a client is just looking for a portfolio that is generally tax-aware, ETF model portfolios can often fill that niche, according to a new analysis by Morningstar.

The Chicago-based fund data provider broke down the returns of returns of Vanguard’s Core and its Tax-Efficient model portfolios between January 2019 and June 2022. Both series of portfolios provide similar exposure to stocks and bonds, but the Tax-Efficient series uses Vanguard’s $18.4 billion Tax Exempt Bond ETF for its fixed-income sleeve. The Core series, on the other hand, allocates money to the $82.6 billion Total Bond Market ETF and the $45.7 billion Total International Bond ETF in the Core series, Morningstar notes.

Morningstar looked at what an investor based in Illinois who rebalanced annually who invested $1 million would fare. The Chicago-based firm found that the tax-efficient versions of Vanguard portfolios generated higher pre-tax and after-tax returns, compared with the tax-agnostic version.

Pre-tax, investors in the tax-efficient versions earned anywhere from $8,110 more than non-tax aware clients through the 80% equity/20% fixed-income portfolio. Those in the 20% equity/80% fixed-income model collected as much as $22,261 more, the report notes. After taxes, the difference grew to $11,386 for the most aggressive model to $38,382 for the bond-heavy version.

Most of the returns came from taxes avoided through rebalancing— not the tax efficiency of the funds themselves, Morningstar notes, which makes sense given both sets of models use tax-efficient ETFs.

To be sure, the tax boost during that 2019-2022 period was relatively modest based on the size of the portfolio: about 32 basis points for the 80/20 model and 160 bps for the 20/80 version. But it highlights there is tax savings to be found in off-the-shelf packaged portfolios.

And as Morningstar notes, there are more tax-focused models to be found these days. Of the 275 models with a tax-managed objective in Morningstar’s database at the end of last year, 46 were launched in 2021, the data and research provider notes.

ETF models often have significantly lower minimums and far less trading to manage – a few tickers versus dozens of individual securities, which can make them easier to use across a practice. Just something to consider as you evaluate tax tactics for clients.

Precious metals aren’t probably the first things to come to mind when one thinks about sustainable investing. In fact, parts of the gold industry account for the single-largest source of man-made mercury emissions, according to a 2019 United Nations report.

But with inflation roaring, and crypto’s failing to act like the great inflation hedge some had hoped for, some ETF sponsors are looking to ways to make gold appealing to the environmentally conscious investor set.

Last week, Sprott Asset Management, partnering with the Royal Canadian Mint, launched the Sprott ESG Gold ETF, which holds gold bullion sourced from companies and mines that its prospectus says meet the Canadian manager’s environmental, social and governance standards. Initially, the gold will come from Canadian mines like Agnico Eagle Mines and Yamana Gold, a press release states.

“Our goal is to answer a number of key questions for investors: where does my gold come from, who produced it and was it produced sustainably by recognized ESG leaders?” said John Ciampaglia, chief executive of Sprott Asset Management, in the release.

The launch follows the June debut of Franklin Templeton’s Responsibly Sourced Gold ETF, which now represents about $34 million in assets, according to Franklin’s website. That ETF holds London Good Delivery gold bullion bars that were refined on or after Jan. 1, 2012, and meet the London Bullion Market Association’s responsible gold guidance, according to Franklin’s fact sheet.

This guidance is focused on miners and producers' ethical and environmental standards, and their ability to demonstrate efforts to combat money laundering, terrorism financing, and human rights abuses, the product sheet notes.

The rise of greener gold ETFs in some ways encapsulates the push-pull of investors when it comes to maximizing returns while minimizing environmental impacts. Commodity-focused ETFs have soared in sales this year, with geopolitical risk sending the price of oil, gas, foodstuffs and other natural resources skyrocketing.

Click on the image to hear Invesco's Anna Paglia discuss demand for commodity ETFs.

And yet, while last quarter sustainable funds in Morningstar’s database saw outflows for the first time in five years the organic growth decline of 0.45% remained less than the overall market decline 0.74%.

It remains to be seen whether more sustainable options reduce a mental barrier of clients to holding gold. But the products still will be subject to the dynamics of the up-and-down gold market.

North American-listed gold ETFs saw $2.5 billion of outflows last month, as gold prices fell 3.5% in the month to $1,753 per ounce, according to the World Gold Council’s July report.

Gold price declines, a strong dollar and strong equity markets, combined with reduced long-holdings in gold futures, likely drove the outflows, the report notes.