ETFs Escape Most Capital Gains
ETFs rarely distribute capital gains, for two reasons. One, ETF portfolio managers are often able to rebalance portfolios by offloading low-basis positions in kind, via the redemption process. Two, ETF investors are insulated from their co-owners’ actions. Cash creations and redemptions expose mutual fund portfolios to both types of capital gains, which must be distributed to fund holders.
The now well-documented “heartbeat” flows enable ETF portfolio managers to rebalance without incurring capital gains charges.
Mutual fund portfolio managers must rebalance directly, by selling portfolio securities and buying new ones. Selling winners means realizing capital gains.
Mutual fund shareholders are on the hook for all realized gains, even for positions initiated long before their own purchase date. Mutual fund shareholders are also on the hook for the tax consequences of fellow shareholders’ redemptions. Mutual fund portfolio managers often have to sell securities to raise cash to meet redemptions. The buy-and-hold investors pay the taxes for the redeemers. Ouch.
That’s not an issue for ETF holders. ETF redemptions are mostly made in kind, generally as a pro-rata share of portfolio securities. The redeeming parties, including the investor and the associated person/market maker, complete the process by selling the securities in the capital markets. No capital gains involved.
There’s another, subtler way that cash creations and redemptions cost mutual fund shareholders, while in-kind transactions place the costs directly on the transacting party. The effects are measurable as tracking difference.
When fund shares—mutual fund and ETF—are created or redeemed, someone has to buy or sell portfolio securities. The trades create a market impact, pushing the prices of purchases up, and depressing the sale price. This impact is spread among mutual fund shareholders, but falls solely on the ETF buyer or seller, without impacting the remaining shareholders.
Because ETF creations and redemptions happen in-kind, a purchaser or seller’s agent must transact in the capital markets, bearing the market impact. The ongoing fund holders do not bear the trading costs or suffer the market impact.
For mutual funds, the capital markets transactions happen after shares are issued or redeemed. For ETFs, capital markets transactions come first, and issuance second. ETFs are very efficient except on the day you buy or sell them. Mutual funds are the other way around.
To meet a purchase order, mutual fund portfolio managers deliver shares at NAV before buying portfolio securities. The new purchases may well cost more than they would have the previous day, by virtue of the presence of the buyer. Trade-day NAVs do not yet incorporate the market impact of the new purchases or sales. The market impact is measurable by tracking error.
This becomes clear when we look at three-year annualized total returns for S&P 500 funds. The three U.S.-domiciled S&P 500 ETFs—the iShares Core S&P 500 ETF (IVV), Vanguard S&P 500 ETF (VOO), and SPDR S&P 500 ETF Trust (SPY)—returned an average of 0.08% per year more than the average of 15 no-load, investor class S&P 500 mutual funds. That’s after the expense ratio was added back in.