ETF Univ: Why Are ETFs So Tax Efficient?

Two of the great, underappreciated advantages of ETFs are their transparency and tax efficiency. Compared with mutual funds, ETFs are light years ahead in these two critical categories.

Better Transparency
One of the key benefits of ETFs is that they offer better transparency into their holdings than competing mutual funds. The ability to verify your positions on a daily basis (in most cases) is a big plus.

By law and by custom, mutual funds are only required to disclose their portfolios on a quarterly basis—and then only with a 30-day lag. Mutual funds can and do stray from their described targets—a phenomenon known as “style drift”—which can negatively impact an investor’s asset allocation plan. In short, when you buy a mutual fund, you’re taking a leap of faith—and in the past, investors have been burned.

ETFs are far more transparent. By custom, most—but not all—ETFs disclose their full portfolios on public, free websites every day of the year.

ETF issuers each day publish the lists of what securities an authorized participant (AP) must deliver to the ETF to create new shares (“creation baskets”), as well as what shares they’ll get if they redeem shares from the ETF (“redemption baskets”). This—combined with the ability to see the full holdings of the index an ETF is aiming to track—provides an extremely high level of disclosure even for those few ETFs that fall short of the daily-disclosure ideal.

Greater Tax Efficiency
ETFs are vastly 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.

Generally, ETFs do much better than actively managed mutual funds.

Why? 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. But they’re 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.

And when an AP redeems shares of an ETF with an issuer, it actually gets even better. When APs redeem 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 cashbased 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.