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With just two days left for filing the income tax, investors are still seeking a variety of avenues to save tax at the last minute. While there are many traditional and legal ways to lower the tax bill, ETFs could be ideal and have now become one of the important tools in planning tax liability.

This is because these are cheap, transparent, and more tax-efficient than mutual funds thanks to their indexing and structure. Their unique strategy of creating and redeeming a large basket of shares in-kind rather than cash results in lower capital gains and thus a lower tax burden (read: 5 ETFs for Your 2015 IRA Contribution).

However, all ETFs are not tax-efficient. As such, investors should focus on some key metrics before planning their tax liability through ETFs. These are portfolio turnover ratio, tax cost ratio, and potential capital gain exposure.  

Behind These Metrics

Portfolio turnover ratio is the frequency at which underlying stocks in the portfolio are bought and sold during the course of a year. The lower the ratio, the more tax-smart the ETF is.   

Tax cost ratio determines the percentage of total annualized return (including all types of dividends) to be paid in taxes, thereby eating away most of the profits. For example, an investor holds a fund with tax cost ratio of 2% that generated about 10% in annual total returns over a one-year period. This will result in after-tax profit of 9.8%. As a result, the lower the ratio, the more the investors can save (read: Most ETFs Are Tax Smart, Is Yours?).

Potential capital gain exposure (PCGE) is a measure of potential future tax liability that investors could face. Basically, it is an indicator of possible future capital gain distribution. A positive PCGE means that some of the securities in the fund’s holding have appreciated and could result in capital gains should the fund manager sell and distribute them. Investors have to pay taxes on these capital gains. In order to avoid this tax headache, a fund with negative PCGE could be better option.   

The combination will create highly tax-efficient ETFs for long-term investors. While there are several equity ETFs that are extremely tax favorable, we have highlighted three funds that provide exposure to the broad U.S. equity market with the help of fidelity screener.

SPDR S&P MidCap 400 ((MDY - Free Report) )

This ETF provides targeted exposure to the mid cap segment of the U.S. stock market by tracking the S&P MidCap 400 Index. The fund holds 402 stocks, which are well spread across a number of securities as each firm holds less than 0.7% of total assets. From a sector look, financials takes the top spot at 23.1% while information technology, industrials and consumer discretionary round of the next two with double-digit exposure each (read: 3 Top-Ranked Mid Cap ETFs to Buy Now).

The product has an annual portfolio turnover ratio of 16.68%, tax cost ratio of 0.49% and a negative PCGE. It is one of the largest and most popular ETFs in the mid-cap space with AUM of $16.9 billion and average daily volume of 2 million shares. The ETF charges 25 bps in annual fees from investors and delivered annual returns of 11.92% as of March 31. The fund has 1.08% in annual dividend yield and has a Zacks ETF Rank of 3 or ‘Hold’ rating with a Medium risk outlook.

Market Vectors Morningstar Wide Moat ETF ((MOAT - Free Report) )

This fund provides an equal weighted exposure to 21 most attractively valued securities having sustainable competitive advantages by tracking the Morningstar Wide Moat Focus Index. Each security holds around 5% share. The product is also spread across various segments with the top four sectors – energy, health care, consumer discretionary and industrials – accounting for double-digit exposure (see: all the Total Market U.S. Equity ETFs here).

The fund has amassed $924.9 million in its asset base while trades in good volume of more than 186,000 shares. Expense ratio came in at 0.49%. MOAT has an annual portfolio turnover ratio of 15.00%, tax cost ratio of 0.57% and a negative PCGE. It returned 4.8% annually over the one year-period as of March 31 and has 1.33% in annual dividend yield.  

iShares Russell 2000 ((IWM - Free Report) )

This is the most popular and liquid ETF targeting the small cap segment of the broad U.S. market with AUM of about $31 billion and average trading volume of more than 35.8 million shares a day. The fund provides exposure to a broad basket of 2,002 stocks by tracking the Russell 2000 Index. It is well spread out across components as none of these holds more than 0.57% of assets.

Sector wise, financials takes the top spot with one-fourth share, followed by information technology (17.9%), health care (15.9%), consumer discretionary (13.8%) and industrials (13.4%). The fund charges 20 bps in annual fees from investors and delivered returns of 8.3% over the past one year. IWM has an annual portfolio turnover ratio of 15.00%, tax cost ratio of 0.57% and a negative PCGE. It has an annual dividend yield of 1.27% and a Zacks ETF Rank of 3 with a High risk outlook (read: Top Ranked Small Cap ETFs for Outperformance).

Below, we have compiled the data and showed how ETFs are tax efficient. Given their lower turnover ratio and no potential future capital gains, these funds could be excellent choices in the portfolio to reduce tax liabilities.

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