Gil’s Musings

How Tax Efficiency Boosts Appeal of ETFs

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.”

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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