It is almost the official start of the holiday shopping season, also known as Thanksgiving. However, just as some retailers have offered savings to early shoppers, ETF providers have offered early tax benefits to investors.
We expect the vast majority of ETFs to have no such gifts for shareholders. In contrast, many mutual funds will be sending an unwelcome present to their investors.
High Tax Bills for Some Mutual Funds
Morningstar does a great job of tracking the capital gains estimates from large mutual fund companies. According to Morningstar research, many mutual funds with the largest capital gain hits had net redemptions of more than 30% of their assets during the year.
For example, the Morgan Stanley Institutional Dynamic Value (MAAQX) is slated to distribute more than 50% in capital gains, due in part to losing roughly half of its shareholder base. Nine other mutual funds in the report were expected to pay out more than 30% of their value as a capital gain. This list is likely to grow as more firms finalize their estimates.
ETFs Usually Provide a Different Experience
Contrast that with the iShares MSCI USA Minimum Volatility ETF (USMV). The factor ETF’s asset base is now $25 billion, partly because of its $6.5 billion of net outflows in 2024 as of mid-November. Despite the sizable redemptions, iShares did not include USMV on its list of a handful of ETFs expected to have capital gains. There are no tax implications for shareholders who owned throughout the year. (If you sell any investment you should expect some tax implications.)
Loyal investors in the SPDR S&P Dividend (SDY) will also not receive a tax bill. This is true even as the $21 billion ETF incurred nearly $2 billion of redemptions this year. A few State Street Global Advisors will have capital gains, but SSGA is not one of them.
Both iShares and State Street Global Advisors are seeing small tax impacts from newer funds.
An Index Mutual Fund is Near the Top of the Naughty Tax List
While SDY and USMV are index-based, shareholders of funds tracking an index may need to prepare for a bill. Morningstar noted that the $700 million Nationwide NYSE Arca Technology 100 Index (NWJCX) mutual fund was on (what I will refer to as) their “naughty list.”
NWJCX tracks a price-weighted index and was impacted by stock splits that contributed to large capital gains. The fund will distribute 20% of its net asset value as a tax this year.
Why Are ETFs Generally More Tax Efficient?
I have covered this in the past on this site, so I’ll leverage a key section. ETFs trade on an exchange where sellers typically transfer shares to another investor. As a result, ETF managers do not need to sell shares of underlying investments to meet redemptions. When they do, ETFs usually make in-kind redemptions through authorized participants using low-cost basis securities rather than cash. Such actions limit the likelihood of realizing capital gains.
In contrast, mutual funds do not trade on an exchange. Fund managers need to sell shares of their holdings to meet redemptions or for more traditional reasons, like taking profits on a strong-performing security. Such changes can create taxable liabilities for the remaining shareholders.
It already is a record year for net ETF flows with more than $900 billion. However, we expect as many advisors hear from clients getting tax bills from their mutual funds, money will continue to flow in. We should even break the $1 trillion ETF net inflows milestone.
For more news, information, and strategy, visit ETF Trends.