More investors are making the switch from open-end mutual funds to exchange traded funds as it has become harder to justify the high fees in underperforming funds. Investors new to the ETF investment vehicle will notice that the two fund structures are also taxed differently.
The ETF’s structure allows for liberal use of “in-kind” redemptions, Paul Justice, Director of ETF Research at Morningstar, and Samuel Lee, ETF Analyst, write in a recent research paper. In this way, the investment exchanges baskets of underlying securities, which do not incur capital gains, instead of making cash transactions. [ETFs and Tax Efficiency]
However, there are instances when trades will result in ETFs distributing capital gains, albeit at a very low percentage. For instance, an ETF may incur capital gains if it changes its portfolio composition frequently while experiencing significant inflows and outflows. Additionally, as funds perform and attract robust inflows, some ETFs may not be able to efficiently move in-kind transactions, notably those in high-yield bonds and some emerging markets, along swaps or futures.
According to the Morningstar, average capital gains distributions in ETFs were 0.0269% over the past 5-years and 0.0513% over the last 10-years, compared to mutual funds with 1.1561% and 0.4630%, respectively.
For the large-cap blend category, the five-year average distribution drops from 1.92% in active mutual funds to 0.16% in passive mutual funds and 0.00% in ETFs.
Additionally, it should be noted that conventional measures of cost, such as expense ratios, tracking errors, indexing methodologies, could exceed normal tax costs. Consequently, the measurable “tax efficiency” could come with lower after tax returns.
For more information on ETF taxes, visit our taxes category.
Max Chen contributed to this article.