Which is more attractive to investors in a high tax bracket: tax managed funds or ETFs?

QUESTION: Which are more attractive to investors in a high tax bracket: tax managed funds or ETFs?

-- Anonymous

ANSWER: No one likes to pay taxes. The good news is that, yes, there are investments that can keep your tax hit to a minimum.

Tax-managed funds and exchange-traded funds are two such vehicles, although they typically avoid the tax man in different ways. (Taxes pertain, of course, only to taxable accounts. In tax-deferred vehicles like a traditional IRA or a 401(k), you needn't worry about taxes until you begin taking withdrawals.)

Tax-managed funds are run by managers who seek to avoid distributing capital gains to shareholders in any given year. Typically they keep the tax hit low by making sure that the taxes generated by selling stocks at a gain are offset by sales of other stocks at a loss.

The tax-efficiency of ETFs, on the other hand, is innate. These investments are tax-efficient because they hew closely to a particular index. That means that unless a company is kicked out of or added to the index, there are no trades within the ETF to create a capital gain or loss, explains Michael Kitces, director of financial planning with the Pinnacle Advisory Group, a Columbia, Md., wealth-management firm.

In addition, ETF shares are traded on an exchange like a stock, which means that investors buy and sell ETF shares from one another (through brokers), as opposed to buying and selling through a fund company. When mutual fund investors sell their shares, the fund has to come up with the cash to buy them out (which may cause it to liquidate some of its holdings). With ETFs, the manager never needs to cash out, explains Michael Porter, senior research analyst at investment-research company Lipper.

Which is the better investment option for tax-avoiders? From a tax perspective, both should be efficient. But investors shouldn't let their fear or loathing of taxes dictate their investment decisions, says Kitces, who cautions against investing in a poorly performing fund just because it's tax-managed. Remember: Taxes become an issue only after capital gains are generated. So an investor should focus first on issues such as management style and cost structure.

Ask yourself: Do you prefer active management or a more passive approach? ETFs passively track an index. With an actively managed tax-advantaged fund, you're paying for investment decisions. Confusing matters even more, there are tax-managed index funds, too, like the Vanguard Tax-Managed Capital Appreciation fund (VMCAX), which tracks the Russell 1000 index, and the Vanguard Tax-Managed Small-Cap Fund (VTMSX), which tracks the S&P SmallCap 600 index. Unlike a traditional index fund, these funds have the flexibility to steer away from their benchmark for the sake of tax efficiency.

Tax-advantaged funds and ETFs also differ in terms of their fee structures. A typical actively managed mutual fund has a significantly higher expense ratio than an ETF. (After all, you're paying a manager to make investment decisions.) That may be worth the added cost, but it doesn't make much sense if you're investing in a fund that holds pretty much the same stocks as an ETF. "You have to look at the actual holdings of the index fund and then look at the holdings of the ETF and verify you're not buying the index anyway," Kitces says.

But while expense ratios on traditional mutual funds may be higher than those on ETFs, ETFs tend to have higher trading costs, since they're bought and sold through brokers. (With a mutual fund, you can avoid these costs by investing directly with the fund family.) These costs won't add up to much if you aren't an active trader -- but if you trade frequently, this route can be pricey. Of course, the more likely strategy for someone seeking tax efficiency is to buy and hold an investment for at least a year. (Short-term capital gains are taxed at income tax rates, while long-term gains -- those held a year or longer -- are taxed at the lower, 15% rate.)

You must weigh all of these factors -- active vs. passive, expense ratios, buy-and-hold vs. active trading -- before making your decision. For our most recent tax-managed fund picks, click here. For more on ETFs, go to our ETF Center. Our ETF Screener is a handy way to find ETFs based on specific criteria.