The last key difference between mutual funds and ETFs is tax efficiency. While both structures are taxed equally on the individual level, the key difference occurs at the fund-holdings level. At the end of the year, if the fund had netted gains from selling securities, this amount must be distributed to the fund’s shareholders, who are then required to pay taxes on this distribution.
ETFs are more tax efficient on the fund-holdings level due to their exchange-traded nature. Shares of the ETF can be passed back and forth on the exchange without creating turnover in the underlying portfolio, thereby reducing the chance for capital gains.
The second contributing reason is due to the “in-kind” creation and redemption mechanism. Securities and ETF shares are exchanged between the authorized participant and the ETF issuer during a creation or redemption, free of payment, meaning no transactions occurred within the portfolio. Mutual funds have neither of these benefits, making them more prone to taxable events.
While ETFs and mutual funds are both a wrapper around a basket of securities, there are many key differences. ETFs provide much more transparency, flexibility, tradability and tax efficiency compared to their mutual fund counterparts.
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The investor knows exactly what he or she holds, and all of the costs and fees are transparent. Furthermore, an ETF investor will not be impacted by the actions of other holders of that ETF, whereas a mutual fund investor is at the mercy of other holders of that fund. So in a world of technology, would you prefer a black-and-white TV or a flat-screen color HDTV?
This article has been republished with permission from Wisdom Tree.