Rather than count the ways, let’s just discuss one for today – tax efficiency.
Traditional Mutual Funds
Traditional mutual funds, like those from Fidelity, Putnam, or any other fund company, have a particular type of accounting that results in tax inefficiencies for investors. Accounting rules for these open-ended mutual funds force all fund shareholders to be viewed communally, sharing in the taxable activity generated by the fund. On the other hand, Exchange-Traded Funds (ETFs) are taxed based on each individual’s tax basis in the shares, and the activity of other investors does not result in shared taxation. This offers ETF investors a significant advantage when seeking long-term compounded return.
Unlike ETFs, open-ended mutual funds are not listed on an exchange. Purchases and redemptions of the fund are handled by the fund; hence they are called “open-ended.” For simplicity, let’s limit our discussion of mutual funds to only stock funds at this point. And let’s call the open-ended fund XYZ Growth Fund (XYZFX) and the exchange-traded fund ABC Growth ETF (ABC).
XYZ Growth Fund
The XYZ Growth Fund owns shares of underlying stocks, and the fund maintains the cost basis for each share it owns. Investors buy and sell XYZFX fund shares every day. To accommodate investors who come and go, a certain amount of buying and selling activity of underlying stock shares occurs in the fund. On some days, there is 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 the cash of incoming shareholders with the fund shares of the outgoing. This happens a lot. But certain days see much larger inflows than outflows (or vice versa), and this mismatch requires action by the fund. Stock buys and sells occur to accommodate the cash entering or leaving the fund.
The sell activity, in particular, means that taxes must be paid. The fund distributes taxable gains to all investors at the end of the year, which washes out deferred gains over time, causing a drag on compounding. This trade activity also contributes to the fund’s operating costs, but we’ll save that discussion for another day.
The communal ownership accounting in open-end funds can result in ugly outcomes, some temporary and some permanent. I say temporary because any unfairness gets squared up whenever a fund shareholder sells the fund. For example, imagine a fund that has 20% profits in every share of stock it owns when a new investor enters the fund. We’ll call him Steve. Soon after Steve buys in, the stock market drops 10%, causing a flurry of outflow from the fund and the taxable activity along with it. Steve is now liable for all the printed profits on stock trades that occurred in the fund for the entire calendar year in which he entered the fund. But he also has a 10% loss on his recent purchase. Imagine his surprise when his year-end statement and 1099 show a taxable realized gain on fund activity of $15,000, while his $100,000 investment is now worth $90,000. The unfairness is temporary because the capital gains on which Steve paid taxes in year one will raise his cost basis so that when he sells his shares down the line, he will not pay them twice. The permanent ugly outcomes of communal accounting involve the loss of compounding from the early payment of taxes like those Steve paid in year one, as well as the functional loss of the step-up in basis rule. Such outcomes are practically impossible in an ETF.
Exchange Traded Funds (ETFs)
ETFs are listed on stock exchanges, like the NYSE. They trade just like any stock, and their price is represented by the aggregate value of the fund holdings divided by the number of shares of the fund that exist, just like an open-ended fund. ETFs very rarely buy and sell the underlying stocks held by the fund. Small ETF trades tend to match up between investors on the exchange, just like any stock trade. However, unlike with their open-end cousins, large flow mismatches do not cause the fund to purchase/sell the underlying securities directly. Rather, ETFs have a mechanism that facilitates an investor arriving or leaving with the fund’s underlying stock holdings in hand. Accordingly, a large purchase of the ABC Growth ETF instantly results in the purchase of every stock share held by the fund in the proper proportion matching the fund holdings. The fund simply issues new ABC shares and swaps those for all the stock shares brought in by the investor. The opposite occurs at redemption (see graph below).
This mechanism is invisible to buyers and sellers, but it occurs behind the scenes, automatically, and is not the activity of the fund itself. 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 ABC shareholder’s cost per unit is tracked, the tax system is in check.
Over several decades, the deferral of gains in ETFs compared to open-end funds can boost returns by a fourth. If those gains are deferred until an owner’s death, it also receives the benefit of a tax-free step-up in basis. Ultimately, this means the ETF could outrun the open-end fund by 2x, though the two funds invest similarly and experience the same investment results.
The ETFs structure virtually eliminates surprise year-end capital gains distributions. This is just one reason why ETFs are the fastest-growing financial product ever created.
Please see IMPORTANT DISCLOSURE information.