Susan Dziubinski: I’m Susan Dziubinski, and I’m Hello, my name is Susan Dziubinski, and I’m with Morningstar. Because they payout smaller and fewer capital gains, exchange-traded funds are more tax-efficient than mutual funds. However, this does not imply that ETFs are tax-free. Ben Johnson joins me to talk about how the capital gains distribution season is shaping out for ETF investors this year. Ben is the worldwide director of ETF research at Morningstar.
Which is better for taxes: an ETF or a mutual fund?
When compared to typical mutual funds, ETFs can be more tax efficient. In general, keeping an ETF in a taxable account will result in lower tax liabilities than holding a similarly structured mutual fund. Both are subject to capital gains and dividend income taxes.
Why are ETFs less expensive than mutual funds?
One of the main advantages of ETFs is that they provide more transparency into their holdings than mutual funds. With Wall Street’s reputation at an all-time low, being able to verify your positions on a daily basis (in most situations) is a huge bonus.
Mutual funds are only obligated to reveal their portfolios on a quarterly basis, and then only with a 30-day lag, by law and habit. Investors have no notion if the mutual fund is invested according to its prospectus or if the manager has taken on unnecessary risks between reporting periods. Mutual funds can and do deviate from their stated objectives, a phenomenon known as “style drift,” which can wreak havoc on an investor’s asset allocation strategy.
In other words, buying a mutual fund is a leap of faith—and investors have been burned in the past.
Vanguard’s ETFs, for example, fall short of this ideal metric. ETFs are not required to publish their whole holdings every day by law. There is, however, a catch for those who reveal less regularly.
Every day, ETF issuers publish lists of the assets that an authorized participant (AP) must submit to the ETF in order to create new shares (“creation baskets”), as well as the shares that they would receive if they redeem shares from the ETF (“redemption baskets”). Even for those few ETFs that fall short of the daily-disclosure ideal, this, along with the opportunity to examine the full holdings of the index an ETF aims to track, gives an exceptionally high level of disclosure.
It’s worth noting that all “actively managed” ETFs are required by law to publish their whole portfolio every day. They’re the most open of all the ETFs.
A capital gain is created when a mutual fund or ETF holds securities that have appreciated in value and sells them for any reason. These sales can be the consequence of the fund selling securities as a tactical move, as part of a rebalancing exercise, or to meet shareholder redemptions. If a fund earns capital gains, it is required by law to pay them out to shareholders at the end of the year.
Every year, the typical emerging markets equities mutual fund paid out 6.46 percent of their net asset value (NAV) to owners in capital gains.
ETFs perform significantly better (for reference, the average emerging market ETF paid out 0.01 percent of its NAV as capital gains over the same stretch).
Why? For starters, because ETFs are index funds, they have much lower turnover than actively managed mutual funds and hence accumulate significantly smaller capital gains. But, because to the alchemy of how new ETF shares are produced and redeemed, they’re also more tax efficient than index mutual funds.
When a mutual fund investor requests a withdrawal, the mutual fund must sell securities to raise funds to cover the withdrawal. When an individual investor wishes to sell an ETF, however, he simply sells it like a stock to another investor. For the ETF, there is no bother, no fuss, and no capital gains transaction.
When an AP redeems shares of an ETF from an issuer, what happens? Actually, things improve. When an AP redeems shares, the ETF issuer normally does not rush out to sell equities in order to pay the AP in cash. Instead, the issuer just pays the AP “in kind” by delivering the ETF’s underlying holdings. There will be no capital gains if there is no sale.
The ETF issuer can even pick and choose which shares to give to the AP, ensuring that the shares with the lowest tax basis are passed on to the AP. This leaves the ETF issuer with only shares purchased at or even above the current market price, lowering the fund’s tax burden and, as a result, providing investors with better after-tax returns.
For some ETFs, the mechanism does not work as well as it should. Fixed-income ETFs are less tax efficient than their equities counterparts due to higher turnover and frequent cash-based creations and redemptions.
But, all things being equal, ETFs win hands down, with two decades of evidence demonstrating that they have the best tax efficiency of any fund structure in the industry.
Why are mutual funds inefficient in terms of taxes?
The taxation of qualifying assets, such as IRAs, 401(k)s, and other tax-deferred vehicles, is very straightforward. When money is taken out of these types of accounts, it is usually taxed at current income tax rates, much like money taken out of a paycheck. There is no tax on prospective gains, dividends, or interest while assets are held in these accounts.
People who hold assets outside of tax-favored accounts such as IRAs face a separate tax problem. Gains, dividends, and interest are all taxed on an annual basis if they exceed losses. This forces the account user to make important judgments from time to time.
What do you do with an account that has made a lot of money? Is the taxed gain worth the allocation shift if you wish to rebalance? Some people may put off rebalancing their portfolio because the taxes they owe could be substantial. Some people, on the other hand, believe that proper allocation is more important than paying taxes on gains.
Although there are other investing possibilities, we will focus on Mutual Funds because they are one of the least tax efficient. With more than half of all American households owning mutual funds and 90% of those funds being actively managed (1), investors must be aware of the potential tax implications.
Tax Inefficiency of Mutual Funds
The turnover ratio for the top ten largest mutual funds by asset size is around 75%. (1). Because mutual fund managers sell or acquire 75 percent of the equities that make up their fund each year, investors will pay greater taxes in the form of distributions. You are responsible for the entire year’s taxable profits, whether you bought the fund early or late in the year. This also implies that you may have made a loss but paid taxes. Embedded gains are the term for this. The investor receives these profits, and the fund’s net asset value (NAV) is reduced by the amount of the profit. The dividend is not a poor deal in and of itself because the investor receives it. It may, however, have a negative impact on an investor who does not want to pay additional taxes on gains when she was not anticipating them, or on an investor in the highest tax band, where these gains are taxed at relatively high rates.
Taxes can be collected in any fund, independent of turnover ratio, by redeeming shares for departed investors. When fund managers are required to sell shares of the fund’s investments in order to provide cash to the investor, this occurs. In addition to these reasons, many mutual fund managers do not have a tax-efficiency mandate, which may cause them to try to clear out any profits in the portfolio at the end of each year in order to avoid the accumulation of huge capital gains from year to year. Mutual fund managers, in reality, are mandated to distribute 95% of their capital gains to shareholders. For individuals who are most affected by taxes, there are alternatives to all of these difficulties.
Do mutual funds outperform exchange-traded funds (ETFs)?
While actively managed funds may outperform ETFs in the near term, their long-term performance is quite different. Actively managed mutual funds often generate lower long-term returns than ETFs due to higher expense ratios and the inability to consistently outperform the market.
Are active exchange-traded funds (ETFs) tax-efficient?
Actively managed ETFs are similar to actively managed mutual funds in that they are actively managed. Both are expected to have higher compositional turnover than their indexed counterparts, and fund managers play a significant role in deciding which holdings to invest in. However, there are a few important distinctions between them.
Actively Managed ETFs Trade Like Stocks
Active exchange-traded funds (ETFs) trade like stocks. Throughout the trading day, they can be bought and sold as often as needed. Mutual funds, on the other hand, only trade once a day, at the end of the trading day.
For investors who want to add some active management to their portfolios, this disparity may not be significant. Both types of actively managed funds have managers who react to market developments in real time, and investors purchase a fund to benefit from its longer-term investing strategy.
The stock-like tradability of actively managed ETFs is important for another reason: You’ll need to stick with active ETFs if you want to buy an actively managed fund in a margin account. You can’t buy mutual funds on margin in most situations.
Actively Managed ETFs Offer Better Tax Efficiency
The tax efficiency of an actively managed ETF is one of its largest benefits. ETFs have fewer taxable events than mutual funds since your money is used to purchase what are known as creation units rather than fund assets.
“Because mutual funds’ assets are purchased and sold, gains are distributed rapidly, according to Meadows. “You’ll have to pay capital gains taxes, which could be low or substantial, depending on how frequently the securities are exchanged in and out of the fund.”
When you sell your ETF shares, however, you only receive capital gains. For those who have active funds in retirement accounts such as 401(k) or Individual retirement accounts, this distinction may be less important (IRAs). Active ETFs, on the other hand, may offer tax advantages to investors who invest in taxable brokerage accounts.
Actively Managed ETFs Have Lower Investment Minimums
To buy mutual fund shares, you may need to meet a high investment minimum, depending on the broker. These minimums can be thousands of dollars, which can make it difficult to invest in a fund. Because ETFs have lower investment minimums than active funds, you may be able to get started investing in an active fund sooner or with a lower initial investment.
Mutual Funds Offer Less Transparency
Friedman claims that, despite the SEC’s new guidelines allowing for less openness in actively managed ETFs, mutual funds remain the least transparent investment vehicle.
“Actively managed ETFs must nonetheless reveal their tracking baskets more frequently, according to Friedman. “Mutual funds may only have to report their holdings once a quarter and are not required to reveal as much information.”
If fund transparency is important to you, actively managed ETFs may be preferable to actively managed mutual funds.
Why would you choose an ETF over a mutual fund?
ETFs are exchange-traded funds that take mutual fund investment to the next level. ETFs can provide cheaper operating expenses, more flexibility, greater transparency, and higher tax efficiency in taxable accounts than traditional open-end funds.
VOO or Fxaix: which is better?
Costs are one of the biggest killers of portfolio development if you’re just starting to invest and learning how fees effect your portfolio. Over the course of 30 years, the difference between a 2% cost and a 0.04 percent fee could cause your portfolio to lose half of its value.
The expense ratio for FXAIX is 0.015 percent, while the expense ratio for VOO is 0.03 percent.
In this instance, both of these funds have a similar fee.
The Vanguard S&P 500 ETF (VOO) is less expensive than 96% of its competitors.
What are the drawbacks of ETFs?
ETFs are a low-cost, widely diverse, and tax-efficient way to invest in a single business sector, bonds or real estate, or a stock or bond index, which provides even more diversification. ETFs can be incorporated in most tax-deferred retirement accounts because commissions and management fees are cheap. ETFs that trade often, incurring commissions and costs; ETFs with inadequate diversification; and ETFs related to unknown and/or untested indexes are all on the bad side of the ledger.
How do ETFs get around paying taxes?
- Investors can use ETFs to get around a tax restriction that applies to mutual fund transactions when it comes to declaring capital gains.
- When a mutual fund sells assets in its portfolio, the capital gains are passed on to fund owners.
- ETFs, on the other hand, are designed so that such transactions do not result in taxable events for ETF shareholders.
- Furthermore, because there are so many ETFs that cover similar investment philosophies or benchmark indexes, it’s feasible to sidestep the wash-sale rule by using tax-loss harvesting.