Unwanted Tax Surprise From Mutual Funds Could Drive More to ETFs | ETF Trends

Mutual funds will likely give investors a big tax surprise this year, but exchange traded fund investors won’t have to worry too much.

American Century, Columbia Threadneedle, Harbor Funds, Invesco, MFS, T. Rowe Price, and Vanguard have all warned investors that their active mutual funds could come with year-end capital gains distributions equivalent to 20% or more of the net asset value of the fund, the Financial Times reports.

Allspring Global Investments, the former fund business of Wells Fargo, even warned that two of its funds could come with distributions of 30% or more of the net asset value, while six others will have at least 20% distributions, according to Cap Gains Valet’s data.

According to Morningstar, some funds from AB, BlackRock, Franklin Templeton, Janus Henderson, and JPMorgan will also distribute double-digit percentage gains.

The mutual fund industry will in total issue about $71.9 billion in capital gains for the first half of 2021, or more than double that of the first six months of 2020, according to the Investment Company Institute data.

In comparison, just 9% of ETFs from BlackRock, Vanguard, and State Street Global Advisors will distribute capital gains this year, according to CFRA research data. Meanwhile, only 2% of the 415 equity ETFs they collectively cover will issue capital gains.

Todd Rosenbluth, CFRA’s ETF research chief, also added that most ETFs passing gains will only distribute 1% of NAV or less.

As tax season hits, many investors will find the benefits of the more tax-efficient ETF investment structure. Tax efficiency has long been a selling point for ETFs, since the wrapper’s so-called in-kind creation and redemption process allows for securities to be exchanged for fund shares, which do not trigger a taxable event. Moreover, passive index ETFs typically have lower turnover rates than active funds, further limiting the potential for capital gains distributions.

“The overwhelming majority of ETFs will avoid the type of punch-to-the-gut taxable capital gains distributions that are in store for a large number of actively managed mutual funds this year,” Ben Johnson, Morningstar’s head of ETF research, told FT.

“I think investors’ tax pain will continue to drive more of each incremental dollar of flows in taxable accounts towards ETFs,” Johnson added.