Advisors Ditch Mutual Funds for ETFs in Year-End Moves

As mutual funds start rolling out their year-end capital-gains distributions to fund shareholders, financial advisors are viewing the annual taxable event as another reason to migrate clients into exchange traded funds. 

Virtually across the board, advisors who have shifted clients out of mutual funds and into ETFs cite capital-gains distributions among the top considerations when making the transition. ETFs rarely distribute capital gains, but it is common among mutual funds, even in years when a fund has a negative return. 

“I have made a conscious effort to move taxable accounts out of mutual funds and into ETFs due to large capital-gains distributions out of mutual funds,” said Crystal Cox, senior vice president at Wealthspire Advisors. 

“It is very hard to do tax planning when we do not know what to expect from mutual fund capital-gains distributions until the end of the year,” she added. “It is very easy, so long as we can mitigate any unrealized capital gains in the mutual funds.” 

Switching to ETFs 

While total long-term mutual fund assets, at nearly $24 trillion, still overshadow the $7 trillion in ETFs, the trend toward ETFs is undeniable, with financial advisors leading the way. 

According to the Investment Company Institute, this year through September, mutual funds suffered more than $386 billion worth of outflows, while ETFs saw net inflows of nearly $330 billion over the same period. 

“ETFs have been gathering assets at the expense of mutual funds for a long time, and that trend is unlikely to break anytime soon given that nearly $24 trillion is still invested in the latter,” said Sumit Roy, senior ETF analyst at etf.com. 

A longer-term perspective shows that mutual funds haven’t experienced a calendar month of net inflows since March 2022, according to Morningstar. 

“Over the 10 years through September 2023, U.S. ETFs have amassed $4.23 trillion in flows, while open-end funds shed over $1 trillion,” Morningstar analyst Ryan Jackson said. 

“It was long believed that the flight from mutual funds to ETFs reflected the transition from active to passive investing,” he added. “That's certainly a huge part of it, as more than 90% of ETF assets are in passive strategies, but the rise of active ETFs and the strong inflows they have generated indicates that there is real appetite for ETFs the structure.” 

Capital Gains  

Lisa Kirchenbauer, founder and president of Omega Wealth Management, has seized on opportunities over the past few years to move clients out of mutual funds and into ETFs and direct indexing with individual stocks to avoid capital-gains distributions. 

“The challenge is that many clients still have embedded gains in those funds over many years,” she said. “We have tried to use tax-loss harvesting, especially in bonds this year, to help with the gains in selling the funds to convert to a new investment strategy.” 

The key, Kirchenbauer added, is getting clients out of the mutual funds before the date of the capital-gains distributions. 

“This is a good year to try to begin making these changes and manage the client's income tax planning more proactively,” she said. 

Regulators Are Watching 

James Lee, founder of StratFI, moved his clients out of mutual funds and into ETFs in June, and he said he wishes he would have done it sooner. 

While capital-gains distributions factored into Lee’s decision to switch clients into ETFs, other drivers related to lower fees and his overall portfolio management process. 

“As I started using rebalancing tools, I found that mutual funds and ETFs don’t always play well together within a managed account, because there’s a mismatch in terms of cash availability and settlement,” he said.  

It took Lee about two weeks to switch his 240 accounts from 80 clients to ETFs, and he estimates a cost savings per account of roughly 0.3%. 

“There’s greater tax efficiency with ETFs, but from a regulatory and compliance perspective, the SEC is looking at the total cost structure of working with an advisor,” he said. 

ETFs in Taxable Accounts 

Keith Spencer, founder of Spencer Financial Planning, said he employs a strategy of using ETFs in taxable accounts and using “whichever is cheaper in retirement accounts.” 

“When it comes to deciding whether to sell mutual funds and buy ETFs, that can cause other tax issues,” he said. “Many people have large unrealized gains in their mutual funds, which means they will owe a big capital-gains tax bill if they sell and that has to be incorporated into the analysis.” 

For clients who are sitting on large unrealized capital gains, Spencer will adjust the portfolio settings to have dividends and capital-gains distributions paid out in cash rather than reinvested.  

“Then, we’ll have them purchase ETFs with the cash,” he said. “The purpose of this strategy is to slowly turn their tax-inefficient mutual funds into tax-efficient ETFs.” 

Contact Jeff Benjamin at [email protected] and find him on X: @BenjiWriter