ETFs' Future: Huge Growth

February 04, 2014


The record for ETFs on taxes is nearly flawless:


This data, which is from our friends at Morningstar, looks at the average annual capital gains distribution from active mutual funds, passive mutual funds and ETFs tracking the equity markets for 10 years through 2011.

It’s not just that ETFs are better, they’re literally infinitely better. I don’t know which emerging market ETF blew the average there, but I’ve got a bone to pick with them.

The reason ETFs are so much more tax efficient than mutual funds is simple: Traditional mutual funds are one of the least tax-fair investment products ever invented.

The emerging markets funds cited above had to pay out so much because the funds held a lot of embedded gains at a time when investors wanted out. When investors cashed out, the funds had to sell those stocks with big gains, and then, by law, they have to pay out those capital gains to all of the shareholders that remained.

It’s a scam. If the tables were turned and it was the ETF structure that caused these horrible tax outcomes for investors who’d done nothing but have the temerity not to sell, there’d be scandalous headlines and congressional hearings.

Investors know this.

Average Mutual Fund Flows By Month (2007-2012)

Courtesy of the Investment Company Institute, here’s the average mutual fund flows by month over five years. The pattern here is unmistakable—investors bail out of their funds at the end of the year to avoid getting capital gains distributions, and pile back in in January. It’s insanity. It’s probably no surprise that ETFs have solid flows in November and December. We’d like to think that’s investors getting smarter.

It’s true that most institutions don’t care about the incredible tax efficiency of the ETF structure, but for individual investors and advisors, this tax story is getting out, and we think it will accelerate growth.


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