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 owns securities that have risen in value and sells them for whatever 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.
Is it true that ETFs are tax-efficient?
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.
What are the tax advantages of ETFs?
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.
How do ETFs help you save money on taxes?
- Due to their unique structure, ETFs receive preferential tax treatment over mutual funds.
- ETF dividends and interest payments are taxed in the same way as the underlying equities or bonds they hold.
- Long-term capital gains rates apply to ETFs held for more than a year, which can be as high as 20%.
Are index funds or ETFs more tax-efficient?
Long-term investors should use tax-advantaged retirement plans like 401(k)s and IRAs to save for retirement. I say this not only because it’s smart — we all know that lowering taxes means more money in your pocket — but also because it allows you to fully ignore the intricate nuances of the tax implications of various sorts of funds.
Both index funds and exchange-traded funds (ETFs) are exceedingly tax-efficient, far more so than actively managed mutual funds. Index funds rarely trigger capital gains taxes because they buy and sell stocks so infrequently.
ETFs have the upper hand when it comes to tax efficiency. ETFs, unlike index funds, rarely buy or sell stocks for a profit. When a shareholder wishes to redeem their shares, they simply sell them on the stock market, usually to another shareholder.
How do exchange-traded funds (ETFs) avoid capital gains?
- Because of their easy, broad, and low-fee techniques, ETFs have become a popular investment tool. There are no capital gains or taxes when ETFs are merely bought and sold.
- ETFs are often regarded “pass-through” investment vehicles, which means that their shareholders are not exposed to capital gains. However, due to one-time significant transactions or unforeseen situations, ETFs might create capital gains that are transmitted to shareholders on occasion.
- For example, if an ETF needs to substantially rearrange its portfolio due to significant changes in the underlying benchmark, it may experience a capital gain.
Are ETFs taxed similarly to stocks?
Dividends and interest payments from ETFs are taxed by the IRS in the same way as income from the underlying stocks or bonds, and the income is reflected on your 1099 statement. Profits on ETFs sold at a profit are taxed in the same way as the underlying equities or bonds.
What are the risks associated with ETFs?
They are, without a doubt, less expensive than mutual funds. They are, without a doubt, more tax efficient than mutual funds. Sure, they’re transparent, well-structured, and well-designed in general.
But what about the dangers? There are dozens of them. But, for the sake of this post, let’s focus on the big ten.
1) The Risk of the Market
Market risk is the single most significant risk with ETFs. The stock market is rising (hurray!). They’re also on their way down (boo!). ETFs are nothing more than a wrapper for the investments they hold. So if you buy an S&P 500 ETF and the S&P 500 drops 50%, no amount of cheapness, tax efficiency, or transparency will help you.
The “judge a book by its cover” risk is the second most common danger we observe in ETFs. With over 1,800 ETFs on the market today, investors have a lot of options in whichever sector they want to invest in. For example, in previous years, the difference between the best-performing “biotech” ETF and the worst-performing “biotech” ETF was over 18%.
Why? One ETF invests in next-generation genomics businesses that aim to cure cancer, while the other invests in tool companies that support the life sciences industry. Are they both biotech? Yes. However, they have diverse meanings for different people.
3) The Risk of Exotic Exposure
ETFs have done an incredible job of opening up new markets, from traditional equities and bonds to commodities, currencies, options techniques, and more. Is it, however, a good idea to have ready access to these complex strategies? Not if you haven’t completed your assignment.
Do you want an example? Is the U.S. Oil ETF (USO | A-100) a crude oil price tracker? No, not quite. Over the course of a year, does the ProShares Ultra QQQ ETF (QLD), a 2X leveraged ETF, deliver 200 percent of the return of its benchmark index? No, it doesn’t work that way.
4) Tax Liability
On the tax front, the “exotic” risk is present. The SPDR Gold Trust (GLD | A-100) invests in gold bars and closely tracks the price of gold. Will you pay the long-term capital gains tax rate on GLD if you buy it and hold it for a year?
If it were a stock, you would. Even though you can buy and sell GLD like a stock, you’re taxed on the gold bars it holds. Gold bars are also considered a “collectible” by the Internal Revenue Service. That implies you’ll be taxed at a rate of 28% no matter how long you keep them.
5) The Risk of a Counterparty
For the most part, ETFs are free of counterparty risk. Although fearmongers like to instill worry of securities-lending activities within ETFs, this is mainly unfounded: securities-lending schemes are typically over-collateralized and exceedingly secure.
When it comes to ETNs, counterparty risk is extremely important. “What Is An ETN?” explains what an ETN is. ETNs are basically debt notes that are backed by a bank. You’re out of luck if the bank goes out of business.
6) The Threat of a Shutdown
There are a lot of popular ETFs out there, but there are also a lot of unloved ETFs. Approximately 100 of these unpopular ETFs are delisted each year.
The failure of an exchange-traded fund (ETF) is not the end of the world. The fund is liquidated, and stockholders receive cash payments. But it’s not enjoyable. During the liquidation process, the ETF will frequently realize capital gains, which it will distribute to the owners of record. There will also be transaction charges, inconsistencies in tracking, and a variety of other issues. One fund company even had the audacity to charge shareholders for the legal fees associated with the fund’s closure (this is rare, but it did happen).
7) The Risk of a Hot-New-Thing
Are ETFs preferable to stocks?
Consider the risk as well as the potential return when determining whether to invest in stocks or an ETF. When there is a broad dispersion of returns from the mean, stock-picking has an advantage over ETFs. And, with stock-picking, you can use your understanding of the industry or the stock to gain an advantage.
In two cases, ETFs have an edge over stocks. First, an ETF may be the best option when the return from equities in the sector has a tight dispersion around the mean. Second, if you can’t obtain an advantage through company knowledge, an ETF is the greatest option.
To grasp the core investment fundamentals, whether you’re picking equities or an ETF, you need to stay current on the sector or the stock. You don’t want all of your hard work to be undone as time goes on. While it’s critical to conduct research before selecting a stock or ETF, it’s equally critical to conduct research and select the broker that best matches your needs.
Are ETFs subject to double taxation?
Exchange-traded funds, or ETFs, are taxed in the same way as their underlying assets are. As a result, if an ETF holds all stock holdings, it is taxed in the same way as the sale of those stocks would be.
You will have to pay capital gains tax if you hold an ETF for more than a year. Any earnings will be regarded as ordinary income if you hold it for less than a year. ETFs that invest in precious metals are the lone exception. If a precious metal ETF holds precious metals, it will be taxed as a collectible, meaning it will be taxed at a maximum rate of 28 percent. For most investors, though, this is still poor news.
How long should an ETF be held?
Holding period: If you own ETF shares for less than a year, the gain is considered a short-term capital gain. Long-term capital gain occurs when you hold ETF shares for more than a year.