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‘Decision 2012’ Through An ETF Lens

U.S. voters head to the polls on Tuesday in a presidential election between two candidates with starkly different views on a variety of issues. That matters to ETF investors, because the outcome of the election could have a direct impact on investment returns.

One issue that comes to mind is the future of tax rates. Much has been said about President Barack Obama’s “Obamacare,” a piece of legislation that promises to shake up health care premiums and the bottom lines of insurance companies, but more importantly to ETF investors, it could have major tax implications on investment income.

IndexUniverse Analyst Carolyn Hill earlier this year outlined just how much higher taxes on things like dividends, interest, and short- and long-term capital gains could be if Obamacare does indeed get rubber-stamped. For the record, Republican-party candidate Mitt Romney has said that if elected, he will overturn this legislation.

Taxes would be going up by 3.8 percentage points on all joint filers with adjusted gross income of more than $250,000, and on single filers with incomes over $200,000—changes that would take effect a full year before the health law is scheduled to kick in, Hill said in her blog back in July.

“This additional tax could potentially have a significant impact on all the dividend-focused ETFs that have been so popular lately,” Hill said. “A 3.8 percentage point tax hike may not seem like a big deal until you consider it in the context of tax rates as they currently stand—and what they could rise to if the Bush-era tax cuts aren’t extended.”

Indeed, dividends are currently taxed at 15 percent, but could be taxed at 18.8 percent next year, and if Bush-era tax cuts aren’t extended, those rates could soar to 43.4 percent, while taxes on long-term capital gains would rise to 23.8 percent, Hill said.

More broadly, there’s a tacit understanding that taxes are probably heading higher, even if that’s not what either former Massachusetts Governor Romney or President Obama are saying.

“Everyone believes that taxes on long-term capital gains will not stay as low as they are in 2012, regardless of who takes office,” ConvergEx Group Chief Market Strategist Nicholas Colas told IndexUniverse. “We have a big deficit to fill and a 15 percent tax rate will not do.”

That reality, Colas stressed, will remain true no matter who takes office in 2013, so bracing for higher taxes on capital gains is pretty much a given.

And while most of the market’s attention right now is being paid to the election itself, Colas said advisors are busy alerting their clients to the implications of a higher tax rate.

Growing outflows from mutual funds, particularly in equities, are an indication that many investors are taking to heart the message that they should be “selling” some of those capital gains incurred over the years before the end of 2012, Colas said.

The core concern is that investors would be wise to take a capital gains tax hit now before rates head higher. The ETF piece comes into focus because they are so much cheaper to own than mutual funds and, moreover, because most are index funds, they are more tax efficient than actively managed mutual funds they’d displace.

“This is good for ETFs,” Colas said. “People are getting out of mutual funds they’ve been in for years, but they want to keep their allocation the same, so they are switching into ETFs.”

Year-to-date, inflows into U.S.-listed ETFs has already surpassed the total inflows for all of 2011, while outflows from equities mutual funds, for instance, have been growing.

“We know those tax rates are unsustainable, so we are going to see mutual fund outflows and ETF inflows accelerate between now and the end of the year,” Colas said.

Sector Differences

On a more granular note, the outcome of the election could have varying impacts on different economic sectors—and on those ETFs tapping into those sectors.

In a note published earlier this year, S'P Capital IQ Analyst Todd Rosenbluth noted that an Obama win would most likely be beneficial for health care and pharmaceutical companies, as they continue to implement Obamacare.

Rosenbluth is also bullish on telecommunication names under an Obama administration, thanks to the government’s support and subsidies geared for broadband expansion.

ETFs such as the Healthcare Select Sector SPDR (XLV) and the Vanguard Telecommunications Services ETF (VOX) would be sitting in the middle of that action, he said in a S'P MarketScope Advisor in September.

A Romney win wouldn’t derail the policies that are currently in place that impact those two sectors, but it could also bring benefits to a slew of other economic sectors such as financials, transportation stocks and coal.

A Romney administration would likely mean turnover of heads in many regulatory agencies, particularly those impacting the financial sector.

“S'P Capital IQ believes that the [Dodd-Frank] legislation created a lot of leeway, allowing less stringent provisions,” Rosenbluth said in the note. “Fair Lending and the Community Reinvestment Act are major initiatives of the current Department of Justice, and we think there would be less pressure on the banking industry from a Romney administration.”

Financial-focused ETFs abound, but Rosenbluth pointed out the iShares S'P Global Financials Sector Index Fund (IXG) as one of the funds that stand to gain from a Romney win.

“The current administration has worked against the coal industry and coal-fired plants, by adding regulation,” Rosenbluth added in the note, pointing out what coal—and transportation companies—stand to gain from an Obama defeat.

“Coal accounts for 25 percent of total railroad revenues, and our analysts think that the rails would benefit from further encouragement of drilling in shale regions since they transport much of the needed pipe and sand along with outbound oil products,” he said.

But at the end of the day, ETF investors could win and lose no matter who takes office in 2013. “This is largely a zero-sum game, as one industry or sector that could benefit from an Obama re-election could be hurt by a Romney victory,” Rosenbluth said.

Deeply Split Electorate

Finally, in a broader sense, the upcoming election could end up making the rift between conservatives and liberals a little deeper.

That seems even more likely on the heels of Hurricane Sandy’s destruction along the eastern shore.

“Superstorm Sandy is a crisis for millions of Americans, just as the Financial Crisis and Great Recession challenged—and continue to challenge—similar numbers of citizens,” ConvergEx’s Colas said in a note published this morning.

“How government—Federal, state and local—respond to crisis has a disproportionate impact on how many Americans view its efficacy in more mundane matters.”

More to the point, Hurricane Sandy has likely increased chances of Romney winning the popular vote—even if Obama’s re-election seems more probable than a Romney victory at this time. In other words, Obama could win the presidency in the electoral college, but risks losing the popular vote.

Colas said that seems more probable after the storm because the damage wreaked by Sandy appears to have disproportionately affected Democratic-leaning voting precincts, meaning a big enough number of Obama supporters may not get to cast their ballots, causing a “split decision.”

That split is something that would be detrimental to the future of the U.S. economy, as prospects of any effective government compromise and action needed to keep it from sliding back into a recession might be doomed.

“The classic case study is the 2000 presidential campaign, where then-Vice President Al Gore won the popular contest by over 500,000 votes but lost the Electoral College after a Supreme Court case,” Colas said.

“While the current rancorous state of D.C. politics has many fathers, the 2000 election would pass any paternity test in assessing why Democrats and Republicans haven’t shared their toys over the past decade,” he added.

The so-called fiscal cliff marked by reduced spending and increased taxes—something many expect to materialize in an Obama win—is a “very scary issue,” Colas told IndexUniverse.

Partisan rancor aside, Colas said the fiscal cliff calls for “Congress to work on a coherent fashion” if it is to address this problem effectively.

But split loyalties will all but ensure a lack of productivity in Washington if one candidate has the office and the other the bragging rights from winning the popular vote.

“Not being productive for another four years is certainly something we can’t afford,” Colas said.

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