Exchange traded funds (ETFs) may snatch up investors from mutual funds as investors see unsatisfactory returns in their mutual funds being taxed. The insult to industry may exacerbate the exodus that mutual funds have been seeing this year as year-end tax bills are opened.

Investors have removed $70.7 billion from stock funds in October on top of $56 billion the prior month, reports Jeff Plungis and Sree Vidya Bhaktavatsalam for Bloomberg.

ETFs offer advantages that may help investors reduce capital gain tax bites in their investments. This makes them attractive – especially at a time like this.

Investors are expected to pay taxes on gains even though average mutual funds declined 40% for the year through Oct. 31. It’s a stunning “kick ’em while they’re down” situation. After taking massive hits to their portfolios all year, investors who are expected to pay capital gains on such drastic losses could find them a very bitter pill to swallow. This could only further damage the trust that investors already are losing in fund companies.

Some of the largest mutual funds out there are seeing big capital gains estimates, despite some having negative performance residing in double digits:

  • American Funds EuroPacific (CEUCX): $71.2 billion assets; down 46.9% year-to-date; capital gains distribution estimate of 4-6% of the share price
  • American Funds Washington Mutual (CWMCX): $52.9 billion assets; down 37.2% year-to-date; capital gains distribution estimate of 1-3% of the share price
  • Fidelity Contrafund (FCNTX): $52.9 billion assets; down 39.9% year-to-date; capital gains distribution estimate of 0.16 cents per share
  • Vanguard PRIMECAP (VPMCX): $23.9 billion assets; down 35.8% year-to-date; capital gains distribution estimate of $3.64 per share

If you are holding a fund, you need to understand what could be coming at tax time and decide whether you want to be around for it. You might consider selling the mutual fund and going to a similar ETF instead before a nasty surprise arrives in the mail.

As the stock markets dropped, ETFs saw a net $2.6 billion increase in assets during October. The tax benefits may help explain this phenomenon.

Generally, mutual fund holders are credited at year’s end for mutual fund managers’ stock sales. They pay for the entire year’s gain from individual securities sales. Short-term capital gains are taxed as ordinary income while long-term gains have 15% tax rate, which is scheduled to go up to 20% in 2010.