The in-kind stock transaction used in the Duracell deal lies of at the heart of every ETF, and has the same benefit: tax efficiency.
Warren Buffett’s Berkshire Hathaway is purchasing Duracell from Procter & Gamble, using P&G stock shares to pay for it. While equity analysts differed on the relative merit of exchanging P&G stock for Duracell equity, they admired the deal’s tax efficiency.
Buffett acquired his P&G stock in 2008. If he were to sell the shares now in order to raise cash for the Duracell acquisition, he would face a hefty tax bill on the gains. By using stock instead, he effectively washes out the gains from a tax perspective.
ETFs do the same thing every day, and with the exact same benefit. In fact, the in-kind trading of shares—which happens behind the scenes—lies at the heart of what makes an ETF an ETF.
ETF’s Better Mousetrap
I’m talking about the process by which new ETF shares are either born or are returned to their maker, so to speak—the creation and redemption process, in other words. I won’t go deep in the mechanics here, but the creation/redemption process unquestionably delivers the same tax efficiency that pundits are praising in the Buffett deal.
Here’s why: When there’s significant selling pressure on an ETF, market makers buy up the ETF shares and deliver them to their maker—the ETF issuer. But the ETF issuer doesn’t pay cash for the ETF shares. Instead, the ETF issuer pays in-kind, using the underlying stocks or securities that are in the ETF’s portfolio.
If these stocks went up in value while the ETF held them, no matter—the gains on those shares are washed away when the shares are exchanged with the market makers.
Taxes: Mutual Funds’ Achilles’ Heel
This stands in contrast with mutual funds, which, if faced with the same scenario, would be forced to sell the shares and take the tax hit on the gain.
Worse, the tax hit isn’t born solely by those selling out of the mutual fund, but is instead paid pro rata by the mutual fund shareholders who remain. That’s right. The folks who stay the course pay capital gains taxes even though they didn’t sell.
The difference is stark, especially in equity ETFs. Here the tally from 2001-2011:
|Capital Gains Distributions|
|Equity Fund||Active MF||Passive MF||ETF|
|Large Cap Blend||1.92%||0.16%||0.00%|
|Large Cap Value||2.01%||0.08%||0.00%|
|Large Cap Growth||1.65%||0.04%||0.00%|
|Small Cap Blend||3.54%||1.31%||0.00%|
|Foreign Large Blend||2.50%||0.32%||0.00%|
Source: Morningstar, 2001-2011
ETFs aren’t perfect in this respect, but their in-kind transactions generally do a great job delivering the exact same tax efficiency praised in Buffett’s latest deal.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at firstname.lastname@example.org.