Why are ETFs Better Than Traditional Mutual Funds?

Rather than count the ways, let’s just discuss one for today – Tax efficiency.

Traditional mutual funds, like we are all familiar with from Fidelity, or 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 shareholders of the fund to be viewed “communally,” sharing in the taxable activity generated by the fund. ETFs on the other hand, are taxed based on each indivudual’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 return. Unlike an ETF (exchange-traded fund; aka closed-end fund), open-ended mutual funds are not listed on an exchange. Purchases and redemptions of the fund are handled by the fund, hence that’s why they are “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.

The XYZ Growth Fund (the 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 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 cash and fund shares between two shareholders. This happens a lot. But lumpy larger purchases and redemptions happen often too, and this mismatch is what 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.

This 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 him entering the fund. But he also has a 10% loss on his recent purchase. Imagine his surprise at his year-end statement and 1099 showing a taxable realized gain on fund activity of $15,000, while his $100,000 purchase is now worth $90,000. It is practically impossible for this to happen in an ETF.

ETFs are listed on an exchange, like the NYSE. They trade just like any stock, and the value 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. Unlike their open-end cousin, ETFs very rarely buy and sell stocks held by the fund. Small ETF trades tend to match up between investors on the exchange just like any stock trade. But investors with large ETF trades will arrive or leave with underlying stock holdings of the fund in hand. Accordingly, a large purchase of the ABC 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).

A sale of ABC shares in the open stock market results in a simultaneous transaction to sell all the underlying stocks. This step is invisible to buyers and sellers, but it occurs behind the scenes, automatically, and is not activity of the fund itself. 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 ABC shareholder is tracking his 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, since it greatly reduces the taxability of fund activity.

This is just one reason why ETFs are the fastest growing financial product ever created.

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