Explaining ETFs’ Greater Tax Efficiency
One of the big selling points for ETFs as investment vehicles is that they’re far more tax efficient than competing mutual funds.
If a mutual fund or ETF holds securities that have appreciated in value, and sells them for any reason, they will create a capital gain. These sales can result either from the fund selling securities for a tactical move, due to a rebalancing effort, or to meet redemptions from shareholders. By law, if funds accrue capital gains, they must pay them out to shareholders at the end of each year.
As a general rule, ETFs do much better than mutual funds when it comes to paying out capital gains. In fact, the vast majority of ETFs don’t pay out any capital gains. According to a blog post on the SPDR ETF website, Morningstar data indicates just 6.2% of U.S.-listed ETFs paid out a capital gain in 2018, but more than 60% of mutual funds did so.
Further, during the past decade, the blog notes, the level of ETFs paying capital gains has remained below 10%. Meanwhile, during the same time period, between 16% and 62% of mutual funds have paid out capital gains during those years, and the trend seems to be moving higher over time.
Why such a huge difference? For starters, because they’re index funds, most ETFs have very little turnover, and thus amass far fewer capital gains than an actively managed mutual fund would. And, as the blog notes, 70% of mutual funds are actively managed. However, ETFs are also more tax efficient than index mutual funds, thanks to the magic of how new ETF shares are created and redeemed.
When a mutual fund investor asks for her money back, the mutual fund must sell securities to raise cash to meet that redemption. But when an individual investor wants to sell an ETF, he simply sells it to another investor like a stock. No muss, no fuss, no capital gains transaction for the ETF.
Even Better With APs
What happens when an authorized participant (AP) redeems shares of an ETF with an issuer? Actually, it gets better. When APs redeems shares, the ETF issuer doesn’t typically rush out to sell stocks to pay the AP in cash. Rather, the issuer simply pays the AP “in kind”—delivering the underlying holdings of the ETF itself. No sale means no capital gains.
The ETF issuer can even pick and choose which shares to give to the AP—meaning the issuer can hand off the shares with the lowest possible tax basis. This leaves the ETF issuer with only shares purchased at or even above the current market price, thus reducing the fund’s tax burden and ultimately resulting in higher after-tax returns for investors.
The system doesn’t work so smoothly for all ETFs. Fixed-income ETFs, which have more turnover and often have cash-based creations and redemptions, are less tax efficient than their equity brethren.
But all else equal, ETFs win hands-down, with two decades of history showing they have the best tax efficiency of any fund structure in the business.
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