How Tax Efficiency Boosts Appeal of ETFs

April 2, 2015 Gil Baumgarten

Exchange-traded funds (ETFs) are among the fastest-growing securities available, having surged in popularity in recent years among individual investors. But are they better than traditional mutual funds? For a host of reasons, yes. But given that this is the time of year when everyone is thinking about taxes, let’s focus on one of the most important ones: tax efficiency.

Traditional mutual funds, like those from Fidelity, Vanguard or any other fund company, have a particular type of accounting that limits tax advantages for investors. Accounting rules for these open-ended mutual funds force all shareholders of the fund to be viewed “communally,” sharing in the taxable activity generated by the fund. Purchases and redemptions of the fund are handled by the fund – that’s why they are “open-ended.”

Segment Wealth Management Blog Exchange Traded Funds tax efficiency

But ETFs are taxed based on each individual’s tax basis in the shares, and other investor’s activity does not result in shared taxation. This offers ETF investors a significant advantage when seeking long-term, compounded returns. In other words, they’re like mutual funds traded like stocks on an exchange, such as the NYSE. And they include the luxury of liquidity for active traders, and reduced costs for buy-and-hold investors.

For simplicity, let’s limit our discussion of mutual funds to only stock funds, and let’s call the open-ended fund XYZ Growth Fund.

The XYZ Growth Fund owns shares of underlying stocks and the fund has a cost basis for each share it owns. Investors buy and sell XYZ fund shares every day. To accommodate investors who come and go, a certain amount of buying and selling activity of underlying stock shares tends to occur in the fund. On some days, there’s perfect balance. Buyers’ and sellers’ purchases and redemptions are simply matched up and no underlying security trades need to take place. The fund simply swaps cash and fund shares between two shareholders.

But larger purchases and redemptions happen too, and this mismatch causes quite a bit of stock buys and sells to accommodate cash entering and leaving the fund. This tends to wash out deferred gains over time, causing a drag on compounding. This also contributes to the fund’s operating costs, but we’ll save that discussion for another day.

Communal ownership can result in some temporarily ugly outcomes. I say temporarily because any unfairness gets squared up whenever a fund shareholder sells the fund. In the meantime, imagine a fund that has 20% profits in every share of stock it owns, even after the stock market has just dropped 10%. When the fund was at its 10% higher price, a new fund investor enters the fund. That investor now owns all the printed profits on other stock trades that occurred in the fund for the entire year prior to entering the fund. Imagine his or her surprise on a year-end statement and 1099 form showing a taxable realized gain on fund activity of $15,000, while the $100,000 purchase is now worth $90,000.

It is practically impossible for this to happen in an ETF. Unlike their open-ended cousins, ETFs rarely buy and sell stocks held by the fund. Instead, the fund simply delivers the stock shares to the seller, and takes back the matching ETF shares. The marketplace provides the cash from all the representative sales. This forces the underlying stock trades to be done outside the walls of the ETF. ETFs do track the underlying cost of shares delivered into the fund, but with rare exception that information is irrelevant. As long as every shareholder is tracking his or her cost per unit, the tax system is in check. This virtually eliminates surprise year-end capital gains distributions. It also results in much better compounding over time because it greatly reduces the taxability of fund activity.

Segment Wealth Management Blog Exchange Traded Funds tax efficiency II

Now let’s compare how these differences affect investors. Imagine an open-ended fund and an ETF with identical holdings. They both also have identical purchase and sale activity that occurs for 20 years with 10% annual returns. A typical open-ended fund could produce a $50,000 profit from a $10,000 investment. This could also result in taxes of $12,000 over the 20 years, netting $38,000 in gains. The ETF could also earn gains on deferring the $12,000 in tax, which could generate another $10,000 in compounded gains. In addition, estate tax laws allow for stepped up cost basis at death, potentially making the ETF far more likely to avoid the $12,000 in capital gains taxes entirely if the investor is patient and never sells. That could make the ETF gain $60,000, not $38,000, after all taxes. And finally, there’s the ETF’s fees, which typically are cheaper than open-ended funds. Under certain circumstances, all of this could mean the ETF with identical holdings produces twice the after-tax dollar return over time compared with its open-ended twin.

Just based on tax efficiency alone, ETFs are among the most innovative investment products to come along in decades.

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