Time Of Year To Remember ETF Tax Magic

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.

The ETF Tax Magic

Most of the time, when an investor sells an ETF, the shares of the ETF trade hands without any trading of the underlying holdings; hence, no taxable events for the other investors. That’s fantastic, but it gets better, and here’s where the surprising tax magic comes in. (Keep in mind that here I am referring to nonleveraged, noninverse ETFs that invest in passive equity indexes. The tax treatment for ETFs in certain asset classes, such as commodities and MLPs, or that invest through futures or derivatives, can be more complex.)

When an issuer goes through the creation/redemption process, it exchanges shares of the ETF for baskets of the underlying holdings through major banks or trading firms called authorized participants (APs). With each redemption, the issuer systematically unloads the lowest basis holdings onto the APs.

For example, suppose IWM has a large stake in Vail Resorts (MTN), from years ago, with a cost basis of $25, and it currently trades around $129. Instead of selling its shares in MTN and taking a huge capital gain, it gives the shares with the lowest cost basis to the APs as part of its exchange for units of IWM, thus shifting the unrealized capital gains away from the fund and onto the market makers who buy and redeem ETF shares.

In general, the more creations and redemptions that occur in an ETF, the more the ETF issuer is able to ratchet up the tax basis in its underlying ETF holdings—and eliminate the tax exposure for the ETF investors.

This process has been phenomenally successful. In fact, the vast majority of nonleveraged equity ETFs has never issued capital gains distributions. ETFs are truly delivering on the promise of tax efficiency.

With the S&P 500 still up 178% from its 2009 low, mutual fund investors should be extra careful to not get stuck with exposure to unrealized gains. For investors looking to optimize after-tax returns, and for their advisors with increased mandates to be true fiduciaries, the tax magic of ETFs should only increase the attractiveness of the ETF structure.

David Lichtblau is CEO of ETF.com and can be reached at [email protected].