The investor in ETF B enjoyed an after-tax return representing 96.8% of the pre-tax return, while the investor in ETF A took home only 96.5% of the pre-tax return. The tax-sensitive investor should choose ETF B, right? Wrong.
ETF A had the higher after-tax return. Assuming that each person invested $100,000 for one year, the investor in ETF A took home $420 more than the investor in ETF B. How can what looks like a less tax-efficient investment be the better choice?
The difference in expense ratio explains ETF A’s advantage. An ETF’s expenses are deducted from the dividend and interest income of the investment. Therefore, ETF A, with its lower expenses, produced more dividend income than Fund B. When taxes came due, ETF A had a higher tax bill than ETF B. However, ETF A still came out ahead because its lower expenses gave it a head start.
Another example helps illustrate the relationship between costs and taxes:
While there are various measures of tax efficiency out there, many don’t capture the ultimate tax—the one investors pay to the investment manager,” Mr. Dickson said. “In effect, higher expenses are a 100% ‘tax’ that’s paid to the fund sponsor, so investors and advisors should give equal weight to expenses when considering an investment’s tax efficiency.”
Notes:
- Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
- All ETF products are subject to risk, which may result in the loss of principal.
- The information provided here is for educational purposes only and isn’t intended to be construed as legal or tax advice. We recommend that you consult a tax advisor about your individual situation.