As tax time nears, investors and advisors should review the different tax treatment—and potential advantages—of exchange traded products.
In addition to their reputation for transparency and low cost, many types of exchange traded products are also known for their tax efficiency, due mainly to their unique structure.
The Power of Tax Efficient Returns
The tax efficiency of exchange traded funds (ETFs), for example, enables many ETF strategies to outperform traditional open-end mutual funds that target the same market sectors—a difference that may exceed 50 basis points a year for investors in the top tax bracket (see table).
For ETF investors, this benefit is largely achieved by delaying recognition of most capital gains, which are recognized when investors sell out of the ETF.
Five-year tax cost ratios: Average mutual fund vs. Largest ETFs (Annualized Percent loss due to taxes)*
| Fund Category | Average Mutual Fund | Largest ETF | Difference |
| Large Blend | 0.68% | 0.34% | 0.34% |
| Small Blend | 0.70% | 0.47% | 0.23% |
| Foreign Large Blend | 1.05% | 0.50% | 0.55% |
| Diversified Emerging Markets | 1.14% | 0.68% | 0.46% |
| Intermediate-Term Bond | 1.56% | 1.37% | 0.19% |
| Source: Morningstar as of 7.31.2012. Covers the period 7.31.2007 – 7.31.2012Assumes investor pays the top tax rates. | |||
It's worth noting that the categories with more active mutual funds—Small Blend, Foreign Large Blend and Diversified Emerging Markets—usuually have the largest difference in tax cost between the average fund and the largest ETF in the category.
The other stock category—Large Blend—typically sees lower tax costs from the ETFs than from the average fund, but less dramatically than the more-active stock categories. Note also that stock ETFs do still have some returns lost to taxes, largely due to taxes on dividends paid out by these funds.
Categories and designation of 'Average Mutual Fund' and 'Largest ETF' are based on Morningstar's assessment. There are other Morningstar fund and ETF categories that may have provided a less favorable result over the time period specified.
* The tax-efficiency for ETFs primarily refers to lower capital gains distributions. This has little impact on fixed income funds, where most of the tax cost comes from interest payments. Since the market environment over the past five years has been fairly flat or negative for most of these categories, there have been relatively few capital gains distributions overall, which means that most of the tax cost in stock funds has been due to dividends. Since ETFs don't have an advantage on dividend taxes, the differences in tax costs between funds and ETFs have been small. During periods where funds have realized more capital gains, however, ETFs have had much larger advantages, especially in the more actively traded categories of emerging market and US small cap stocks.
When an investor redeems shares in a mutual fund, the portfolio manager must often sell underlying positions to raise cash, potentially realizing capital gains that would be distributed to all shareholders. By contrast, purchases and redemptions of shares of an ETF are done by large institutional investors called Authorized Participants. These Authorized Participants purchase and redeem shares in large blocks of shares, called "creation units."
Purchases and redemptions of creation units are done in-kind, which means that the Authorized Participant contributes a basket of securities with a value equivalent to 50,000 shares or 100,000 shares of the ETF. The Authorized Participant then takes the ETF shares that have been created and trades them on a securities exchange, where individual investors can access them.
In-kind purchases and redemption enable a more tax-efficient means of managing an ETF portfolio since redemption requests from Authorized Participants can be honored by returning them the lowest-cost tax lots of the securities in the ETF's portfolio. By being able to redeem in this way, the ETF avoids the build-up of capital gains at the portfolio level. This helps spare individual investors from the annual capital gains distributions that are prevalent among open-end mutual funds.
This key distinction allows ETFs to be more tax efficient than mutual funds. Therefore the after-tax results for these vehicles, particularly with respect to capital gains, can be quite different (though it is important to note that investors in ETFs and other exchange traded products must pay tax on distributed dividends and interest).
Different Transactions Create Different Tax Liability
While many exchange traded products may be more tax efficient than mutual funds, different types of products may create different kinds of transactions, and thus different kinds of tax liabilities. Passively-managed index ETFs generally buy or sell securities potentially resulting in a realized long or short capital gain, under one of two scenarios, both of which involve a change to the index tracked by the ETF.
