Exchange Traded Funds, or ETF’s, are often cited as being more tax efficient than mutual funds. Generally speaking, for a long term holder using a taxable account, an ETF will likely be more tax efficient than a comparable mutual fund since you will not owe a lot in taxes just for holding onto the ETF. The reason for this is primarily due to the different ways redemptions and rebalancing occurs within the two investment products.
Mutual Fund Redemptions
Mutual Funds are bought and sold through the mutual fund company. Even when the investor is using an online trading platform such as TD Ameritrade, etc., the funds are transacted through the mutual fund company. Therefore, whenever an investor decides to buy or sell shares of a mutual fund, the fund manager(s) will increase/decrease fund holdings at their discretion. If the fund manager receives a large order to redeem shares, it is likely that they will have to sell part of the fund’s holdings in order to have sufficient cash to meet the redemption request. The selling of holdings will most likely result in capital gains, and those gains will get passed on to all shareholders (not just those who are redeeming) who are then liable for the taxes due on the realized gains within the fund. In other words, when you hold a mutual fund in a taxable account, you are subject to tax based on the activity within the fund based on the actions of fund managers and other investors, and not by you. When you sell the fund, you will still be liable for taxes as a result of capital gains achieved from your total cost basis.
ETF Redemptions
One difference of Exchange Traded Funds are that they are actively traded on exchanges between investors, not the ETF company. When an investor chooses to sell any portion of their ETF holding, they will sell it to another investor. In most cases, there is no need to liquidate any holdings within the ETF and thus, there are no capital gains passed through to any of the other investors who own the same ETF. Typically, investors in an ETF will only realize a taxable capital gains event when they choose to sell shares.
Phantom Gains
Another potential tax disadvantage for the mutual fund owner is referred to as “phantom gains.” Mutual fund phantom gains occur when an investor purchases mutual fund shares shortly before the fund manager decides to sell a substantial fund holding. It is not uncommon for active mutual fund manager’s to choose to sell all of a stock holding if he/she believes that it is no longer optimal to have that holding, or to improve the appearance of the fund prior to a quarterly reporting period. If that holding has appreciated the sale will create a capital gains event. Unfortunately, newer investors in the fund will be taxed on gains that they may not have actually achieved. Hence, “phantom gains.” This is not the case, however, for ETF’s. Since securities inside the ETF portfolio are typically exchanged “in-kind” through APs, (institutional level Authorized Participants) the ETF investor rarely gets burdened with a capital gain due to the sale or exchange of securities.
It is important to note that ETF’s do not provide a tax efficiency over a comparable mutual fund due to their structure. Both are identical in that they “pass through” distributions (interest payments, dividends, or capital gains) to their shareholders. In fact, as long as there are no inflows or outflows, an ETF that is identical to a mutual fund in every aspect would have the same capital gains distribution. The tax efficiencies are created as a result of how the fund manager(s) handle the redemption requests, as well as how often they change their holdings. Therefore, a passively managed index fund could be very tax efficient, while an actively managed small-cap growth fund may be much less efficient due to a higher turnover and likely shorter average holding period for investors.
In January 2012, Morningstar Research published a whitepaper titled, ETFs Under the Microscope: Tax Efficiency Survey, by Paul Justice, Director of ETF Research and Samuel Lee, ETF Analyst. The researchers did a great job of going into detail on how ETF’s and mutual funds differ with regard to shareholder taxes. In the whitepaper, one of the conclusions that they draw is: “… what we have found over the past five years is that ETFs are indeed very tax efficient, but so are passive and tax-managed mutual funds. To claim absolute tax superiority simply because a fund is structured as an ETF is hyperbolic. Tax efficiency, strangely enough, is only one small component of after-tax performance. Conventional measures like expense ratios, tracking error, index methodology and replication methods may have return ramifications that exceed tax cost efficiency gains. By making these sacrifices, the fund may improve tax efficiency while reducing after-tax returns and overall efficiency.”
In the end, anyone who recommends that you avoid mutual funds and buy ETF’s because ETF’s have a better tax structure is just plain wrong. Tax efficiency is irrelevant when you are considering an investment inside a tax favored account such as an IRA or Roth IRA. Plus, reinvestment of dividends and interest, which is a great way to grow your portfolio, has been made easy by the mutual fund companies. With ETF’s though, if your brokerage firm or ETF provider does not offer a dividend reinvestment plan (DRIP) you will have to manually purchase additional shares and incur a trading fee when you want to reinvest the proceeds. In a taxable brokerage account, tax efficiency may be overshadowed by expense ratios, tracking error, methodologies and dividend reinvestment time and costs.
I believe that ETF's are an excellent investment tool and appropriate for all investors. However, while they might be appropriate, I wouldn't consider them to be the best investment for every circumstance. It is important that you do a little homework before the selection of any mutual fund or ETF. Not doing so could result in an unfavorable tax event or increased costs from reinvestment fees. If you are unsure, you should seek the assistance from an impartial professional who utilizes both types of investments in their strategy recommendations. This would typically be someone who manages assets on a fee-only or even a fee-based structure.
Kevin Warman
Last Updated 6/23/2016