ETF Trends
ETF Trends

More are taking a shine to passive, index-based exchange traded funds as disillusioned active mutual fund investors become fed up with underperforming assets and a large tax bite.

Many mutual fund investors with taxable accounts are discovering that their active funds realized significant capital gains that need to be paid taxes on, reports Kelley Holland for CNBC.

According to CapGainsValet, about 453 mutual funds estimated their capital gains distributions would be over 10% of net asset value, 52 calculated distributions would exceed 20% and 12 projected distributions of over 30% as of December 15.

To add insult to injury, investors would have to fork over the high capital gains as most actively managed funds underperformed benchmark indices and passive funds. According to Lipper data, about 85 of active large-cap stock funds failed to even match their benchmark indices. [Why Active Funds Are Underperforming Index ETFs]

Consequently, more investors are turning toward passive fund options, like index-based ETFs. For instance, investors poured a record $215.5 billion into Vanguard funds last year, including $75.3 billion into Vanguard ETFs. The ETF industry itself reached another milestone in December, accumulating $2 trillion in assets under management. [U.S. ETFs Top $2 Trillion in Assets]

“In taxable accounts, actively managed funds are really tough,” Mark Wilson, chief investment officer of The Tarbox Group, said in the CNBC article. “It’s really difficult to beat indexing.”

Whenever a mutual fund sells a position at a gain, the taxable income is passed through to shareholders, even if distributions are then reinvested back into the fund. In contrast, ETFs limit these capital gains distributions through so-called in-kind swaps where securities are exchanged for ETF shares or vice versa, which do not trigger a taxable event. [Why Some ETFs Can Issue Capital Gains Distributions]

Moreover, more investors are beginning to realize that the higher fees associated with active mutual funds are weighing on overall returns. According to the Investment Company Institute, average fees on actively managed equity funds were 89 basis points in 2013, compared to 12 basis points for index equity funds.

The average investor may be better off with a passive index-based ETF.

“Index funds are a good long-term strategy for folks that don’t necessarily have an expertise in picking managers, or picking stocks themselves. That’s going to be the majority of us,” Stephen Horan, managing director at the CFA Institute, said in the article. “Are there active managers that have key insights and a steely discipline and an ability to capitalize and execute on those insights? I think the answer is yes. But they are not the norm.”

For more information on the fund industry, visit our mutual funds category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.