ETFs v. Mutual Funds: Morningstar Analyzes Tax Efficiency | ETF Trends

An ETF’s tax efficiency has been a key selling point for tax-sensitive investors who prefer greater control over the timing and magnitude of the capital gains bills from the funds in which they invest.

Morningstar’s director of global ETF research, Ben Johnson, and Alex Bryan, director of passive strategies research, published a report on Thursday measuring ETFs’ tax efficiency against both actively managed and index mutual funds.

“With active equity mutual funds continuing to bleed assets in the midst of a buoyant market environment, investors in these funds should expect to see some cap gains bills in the mail later this year,” Johnson told ETF Trends and ETF Database. “While our data shows the ETF can be a more tax-efficient format for packaging and delivering active strategies, the pickings for investors are slim when it comes to active ETFs—especially outside the realm of short duration bond funds, which have captured the lion’s share of active ETF assets.”

Results of the study found that:

  • ETFs tend to be more tax-efficient than mutual funds, chiefly because they tend to distribute fewer (if any) and smaller capital gains.
  • Low turnover partially explains ETFs’ tax efficiency. As of March 2019, 84% of ETF assets were invested in funds underpinned by market-cap-weighted indexes. These funds’ turnover was markedly lower than any other cohort examined—save for index mutual funds tied to similar benchmarks.
  • ETFs’ structure is the primary driver of their tax efficiency. The ability to regularly purge low-cost-basis securities in-kind is a key advantage over traditional open-end mutual funds and has allowed even high-turnover strategies to avoid distributing gains.
  • ETFs usually have a more-favorable tax profile than open-end index mutual funds that track the same benchmarks. This is because outflows tend to hurt open-end mutual funds’ tax efficiency, while ETFs tend to be resilient.
  • While ETFs are more tax-efficient than mutual funds, they are not immune to taxation. Their primary benefit from a tax perspective is that they allow investors to defer the realization of capital gains taxes.

Click here to read the report measuring ETFs’ tax efficiency against both actively managed and index mutual funds.