Since the birth of the U.S. ETF industry in 1993, actively managed mutual funds have bled $5 trillion in assets, per recent analysis by BofA. Much of that shift has benefited ETFs as advisors and investors gravitated to passive products with lower fees. However, actively managed ETFs are among the fastest-growing products in the broader ETF space. That confirms active investing isn’t dead — not by a longshot. It’s merely experiencing a rebirth thanks to the ETF wrapper.
One reason for that renaissance is active ETFs enjoy the same tax perks as their passive counterparts. Those benefits aren’t usually found with active mutual funds. Those tax advantages could be catalysts for asset growth for active ETFs like the ALPS Intermediate Municipal Bond ETF (MNBD), the ALPS Active REIT ETF (REIT) and the ALPS/SMITH Core Plus Bond ETF (SMTH).
Active Tax Benefits Look Familiar
One reason active ETFs are more tax efficient than mutual fund equivalents is because ETFs, active and passive, have a creation and redemption process that features in-kind transactions. Mutual funds don’t have that.
“Part of the pull of active ETFs is their supposed tax efficiency. Unlike mutual funds that must buy or sell holdings to accommodate flows, ETFs can do in-kind [transactions. That] means the ETF can exchange underlying holdings for ETF shares,” noted Morningstar analyst Stephen Welch. “For example, if an ETF has a big capital gain in a holding it is looking to get out of, the ETF can exchange the shares of stock for ETF shares without creating a taxable event.”
Regarding capital gains, experienced mutual fund investors know about that taxable scenario all too well. When the fund’s managers sell part or all of a winning position, the tax liabilities aren’t absorbed by the issuer. Rather, they’re passed onto the fund’s investors.
Capital Gains Events Less Likely
Highlighting the allure of active ETFs, it’s rare that active ETFs deliver capital gains distributions. It’s expected that this year the 25 largest funds in the active ETF category won’t pass on any such distributions to investors. Interestingly, ETF versions of active mutual funds are much less likely to have capital gains events than their mutual fund relatives.
“While in most cases the ETFs launched more recently and thus have less embedded gains than their mutual fund counterparts, let’s look at the capital gains distributions these clones put out in 2023 to compare the relative tax advantages of each type. Not surprisingly, the mutual fund vehicles typically paid out more gains than the ETF versions. Only 4.0% of ETF clones paid out capital gains last year, while 26.5% of mutual fund counterparts made such distributions,” added Welch.
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