Exchange-traded funds, or ETFs, are significantly more tax-efficient investments than mutual funds. One of the main reasons ETFs are more tax efficient is due to the fact that they generally create fewer taxable events than most mutual funds.
Most ETFs only sell holdings when the elements that compose their underlying index change. This in turn produces a relatively low turnover rate (the average turnover rate for an ETF is less than 10%), which means significantly lower taxable gain events.
The primary differential in tax efficiency stems from the fundamentally different way in which ETFs are structured, or the specific type of investment asset they are as compared to mutual funds.
Investing in ETFs vs. Mutual Funds
One of the key structural differences is that ETFs are traded on exchanges just like individual stocks, whereas mutual fund shares are bought and sold directly from the mutual fund company. Due to this difference, when investors decide to sell their mutual fund shares it affects all other shareholders tax liability. It is quite likely and very common for the fund manager to sell part of the mutual fund’s holdings to have sufficient cash to pay for the shares being sold or redeemed. This selling of portfolio holdings most likely results in some level of capital gains being realized, and those gains are then passed on to fund shareholders who are liable for the taxes due on the realized gains. ETF shares do not work that way. ETF shares are simply traded back and forth, through an exchange, between individual shareholders. Therefore, there is no need to liquidate any of the ETF’s holdings to pay sellers of ETF fund shares, and thus, no capital gains are produced. Hence, ETFs are more tax efficient than mutual funds.
Phantom Gains Another tax disadvantage for mutual funds arises from what are referred to as “phantom gains”. Phantom gains occur when an investor happens to buy mutual fund shares just prior to the fund manager making a large sell of fund holdings. In an actively managed mutual fund, the fund manager may choose to sell all the fund’s shares in a stock that has appreciated in price. It could also be that the fund manager wants to improve the appearance of the fund’s return just prior to a reporting period or simply that they believe the stock has exhausted its upside potential.
The sale creates capital gains and resulting tax liability for fund shareholders. For shareholders who have invested in the fund for quite some time, the gain in the Net Asset Value (NAV) of their shares since buying into the fund may more than compensate for any resulting tax liability. However, newer shareholders can experience the unfortunate circumstance of being taxed on gains that were of little or no benefit to them. Thus, the term, phantom gains. This does not happen to investors in shares of ETFs.
Investors should note that the ETF tax advantage, while still significant, is typically less significant for fixed-income ETFs. This is because such ETFs usually have higher turnover rates and more redemptions that create taxable events.
Other Advantages of ETFs
ETFs have additional investment advantages over mutual funds. One big advantage is better transparency. An ETF’s holding can be seen daily while mutual funds only disclose their holdings on a quarterly basis.
ETFs provide greater liquidity than mutual funds as they can be traded intraday but mutual funds can only be bought or sold at the end of a trading day. Not having the ability to trade in “real time” is a major disadvantage of trading mutual funds.
Another advantage to holding ETFs is the lower expense ratio in comparison to that of a mutual fund. On average, the expense ratio for an ETF is less than half the average mutual fund expense ratio.
As ETFs continue to grow in popularity, they should continue to capture market share. The structural difference and potential absence of long-term capital gains in ETFs makes them a compelling investment vehicle. Coupled with intra-day pricing, daily liquidity and transparency, ETFs may one day overtake mutual funds.
For more information contact OTA Tax Pros.