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%.
What is the most tax-efficient ETF?
What is the tax efficiency of ETFs? ETFs, unlike mutual funds, do not typically sell equities to raise cash to cover redemptions. Instead, they use a “in-kind” approach to meet redemptions without having to sell securities and realize capital gains. Almost all ETFs in the United States attempt to track the performance of an index.
Which is better for taxes: an ETF or an index fund?
If you’re an active trader or simply prefer to apply more advanced tactics in your purchases, an ETF is the way to go. Because ETFs are traded on exchanges like stocks, you can use limit orders, stop-loss orders, and even margin to purchase them. With mutual funds, you can’t apply such kinds of methods.
If you’re investing in a taxable brokerage account, an ETF may be able to provide you with more tax efficiency than an index fund. Index funds, on the other hand, are still quite tax-efficient, therefore the difference is insignificant. Don’t sell an index fund to acquire an ETF with the same performance. That’s basically asking for a slew of tax complications.
If your broker charges hefty commissions on your transactions and you want to be fully invested at all times, invest in an index fund. You may be able to start investing in index funds with a lower minimum than an identical ETF in some situations.
When the similar ETF is thinly traded, resulting in a huge disparity between the ETF price on the exchange and the value of the underlying assets held by the ETF, index funds are an excellent solution. The net asset value will always be used to price an index fund.
Always compare fees to ensure you’re not overpaying for your preferred option. If you’re deciding between an ETF and an index fund, the expense ratio can help you decide.
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 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.
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.
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.