The beginning of the year allows investors to reset their portfolios, but to also strategically allocate their capital into more tax-efficient investment vehicles. One of those vehicles is the exchange-traded fund (ETF), which is lauded for its tax efficiency.
The ETF is often compared to the mutual fund when weighing the pros and cons of various investment vehicles. With tax season looming, here are three reasons why ETFs are tax efficient.
Legal Structure
The tax efficiency of ETFs is inherent in their legal structure as opposed to a mutual fund. Most ETFs are structured as open-end funds, which fall under the regulatory measures of the Investment Company Act of 1940.
As opposed to mutual funds, shares of an ETF are simply bought and sold through an exchange. Mutual fund shares are bought and sold directly through the mutual fund company, so the actions of other fund investors can affect an individual investor’s tax liability.
In essence, an individual tax investor doesn’t have control of the actions of his or her fellow mutual fund investors. In addition, a mutual fund manager must sell a portion of the fund’s holdings for shares redeemed, which could result in capital gains.
Those capital gains realized are then passed on to mutual fund investors. ETFs are not exposed to this type of taxable event.
The tax implications for ETFs can also vary according to their legal structure. A tax professional can help an investor navigate through the tax ramifications for each type of ETF structure.
Five types of ETF structures:
- Open-end funds: this structure is typically used for stock and bond asset classes.
- Unit investment trusts: typically used to track broad asset classes.
- Grantor trusts: typically used for physical commodities and currencies
- Exchange-traded notes: don’t hold underlying assets, but contain prepaid forward contracts
- Partnerships: unincorporated business entities that elect for taxation as a partnership
Fewer Taxable Events
The ETF is often praised for their tax efficiency since they use an in-kind exchange with an authorized participant. This means an ETF manager uses an exchange to sell the basket of stocks in a fund.
This allows the authorized participant to shoulder the impact of capital gains taxes. As mentioned, a mutual fund that must sell stocks in order to cover redemptions. This creates a scenario where the fund pays capital gains taxes that are passed on to the investor.
Certain ETF products could be subject to capital gains taxes, such as actively-managed funds. For these funds, a higher degree of buying or selling could result in more capital gains taxes incurred.
Still, most ETFs sell holdings only when the factors affecting their underlying index change. This results in a lower turn over ratio that creates taxable events.
Per Investopedia, some actively-managed mutual funds have a turnover rate of 100 percent. In contrast, the majority of ETFs have a turnover rate that is less than 10 percent.
Lack of Phantom Gains
Phantom gains consist of capital gains that an investor owes taxes even if the actual return realized on the investment results in a negative return. In the world of mutual funds, phantom gains can occur when an investor purchases shares of a mutual fund before a fund manager sells a large portion of holdings.
The fund manager’s sale of the holdings creates a taxable event. As such, any capital gains realized on the sale are then passed on to mutual fund investors.
Because of the way ETFs are structured, they do not expose themselves to these phantom gains. Securities within an ETF portfolio are exchanged and created through an in-kind exchange.
This results in the securities returned on a low-cost basis and received at a higher cost basis, which limits tax liability. This results in lower capital gains taxes as opposed to a mutual fund engaging in a similar transaction.
For more educational information on ETFs, click here for Education Central.