Time Of Year To Remember ETF Tax Magic

April 12, 2016

For U.S. taxpayers, the dread of tax-filing season is now upon us in full force. After all, it’s not the nominal investment return that matters, but the after-tax return.

While many investors appreciate the relative tax efficiency of the ETF structure, even seasoned professionals are often unfamiliar with some of the surprising tax magic that makes ETFs the most tax-efficient vehicles available.

When I started making personal investments (prior to the advent of ETFs), I kicked it off with two of the biggest rookie mistakes in the book. The first rookie move was investing through a “hot” mutual fund company that caught my attention with its advertised “5-star” funds. Of course, ETF.com readers know the folly of investing in active mutual funds as ranked by past performance.

But the even more dramatic rookie move was investing in the fund only a few weeks before its annual capital gains distribution. It turns out the hot fund was sitting on large capital gains when I got in. So within weeks of making the investment, I was handed 20% of my investment back, along with the capital gains tax liability—on gains I hadn’t realized.

Mutual Fund Flaw Exposed

This is a significant and fundamental flaw with the mutual fund structure. When investors in a mutual fund redeem for cash, the fund has to sell shares in its holdings, triggering taxable events. That taxable income eventually makes it way to the remaining investors in the fund.

Of course, with actively managed mutual funds, the tax efficiency gets far worse, as all turnover results in taxable events that provide for tax drag. As ETF.com columnist Larry Swedroe reported last week, the negative impact from mutual fund capital gains distributions in the annual S&P Active Versus Passive (SPIVA) scorecard for 2015 was 1.70%.

Passive index-based mutual funds manage to avoid most of the tax drag by not trading, and some do an impressive job keeping tax drag to a minimum. But even index mutual funds still face the same underlying structure.

For example, let’s compare Fidelity’s Spartan Small Cap Index Fund (FSSPX), designed to track the Russell 2000 Index, with the iShares Russell 2000 ETF (IWM | A-90). In the past two years, the mutual fund distributed a total of 4.9% in capital gains. The ETF: zero.

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