Year end is the perfect time to consider the advantages of the ETF structure over traditional mutual funds. The creation/redemption mechanism that differentiates ETFs from mutual funds and hedge funds allows ETF managers to wash out realized gains. When it works well—when two-way flows are frequent and when portfolio turnover is low—ETFs often pass through zero capital gains to their holders. That’s a fantastic holiday gift.
ETF: A Better Mousetrap
The contrast between actively managed mutual funds and ETFs is stark.
Even at Vanguard, where keeping investor costs low is a primary mission, seven actively managed mutual funds will pay over 5% of their net assets in capital gains. The Vanguard Explorer fund is estimated to distribute 11.47% of NAV to shareholders, even those who sold no shares during 2017. There are more extreme cases. Principal Financial expects to distribute 31.07% of NAV in its Large Cap Growth Fund this year. For high-income shareholders, the federal tax bill could come to 7.18% of their entire investment.
Yet ETFs largely avoid passing on these gains, using two methods. First, most ETFs create and redeem shares in kind. This allows portfolio managers to pass low-basis positions out of the portfolio without selling them. No sale, no realized gain, no tax. Second, many ETFs track low-turnover indexes, so ETF portfolio managers seldom need to realize gains in a rebalance.
Are there exceptions? Absolutely. We’ll take a look at those in a minute, but first, let’s examine the tax efficiency of ETFs.
Nearly every large asset manager offers a fund tracking the S&P 500. Many track their indexes well, and compete on cost. Yet the ETFs far outperform the mutual funds when it comes to issuer-provided estimated 2017 capital gains distributions, as shown in the table below. It’s hard to beat 0.00% capital gains distributions, which is exactly what the ETFs deliver. The mutual funds are less efficient.
Here’s where the magic of in-kind redemption comes into play. ETFs generally use an in-kind redemption process, in which the agent transacting with the issuer receives a basket of securities in exchange for the ETF shares tendered. ETF portfolio managers are able to select their lowest-cost-basis positions for exchange. No gains are realized in this swap.
Mutual fund portfolio managers must sell portfolio securities to raise cash to meet redemption requests. Profits realized must be distributed amongst all shareholders, and realized gains must be distributed to shareholders within the calendar year. That’s how the low-turnover Principal Large Cap S&P 500 Index fund ended up generating 5.87% of capital gains distributions for its shareholders. At the highest capital gains rate, that translates into a tax bill of 1.40% for 2017.
When it comes to tax efficiency, in-kind redemptions make ETFs shine.