Why are ETFs so tax efficient?
Exchange-traded funds (ETFs) are well-known for their low costs and liquidity, but many investors ignore an additional, undervalued benefit of ETFs: tax efficiency. In this crucial aspect, ETFs outperform Mutual Funds by a long shot.
ETFs may owe this tax efficiency to their very structure and their trading, creation, and redemption. Structural components contribute to tax efficiency; lower turnover in passive strategies than active strategies, secondary market trading possibilities, and the structural tax advantages of in-kind redemptions.
As a result, ETF investors have more control over when they pay taxes, i.e., when they sell their shares, rather than when other shareholders buy and sell.
In the USA in 2018, only 10% of ETFs paid out capital gains to investors, but 61% of mutual funds did. Mutual funds paid an average of 4.5 percent capital gains as a percentage of NAV, while ETFs paid only 0.2 percent.
How are ETFs are so tax efficient
According to Morningstar, only 4% of mutual funds are passive, compared to 89 percent of ETFs. Passive strategies, on average, have lower portfolio turnover than active methods.
As a result of the decreased turnover, there are fewer instances of securities selling at a profit, and hence fewer opportunities for shareholders to receive capital gains.
Thus, the very basis of management of a fund leads to lower or higher tax efficiency. A passive ETF is more tax-efficient than the actively managed ones, as passive strategies eliminate the need for continuous rebalancing.
Secondary market trading
Unlike mutual funds, exchange-traded funds (ETFs) get traded on stock exchanges. Only 10% of ETF trades affect the underlying portfolio through the primary market, with the rest occurring between investors in the secondary market.
On the other hand, all activity of mutual funds has to occur in the primary market, affecting the underlying portfolio.
When a mutual fund investor requests a redemption, the fund has to sell the securities to cover the obligation. On the other hand, when an individual investor wishes to sell an ETF, he simply sells it in the secondary market. For the ETF, there is no bother and so no capital gains transaction.
This structural difference limits the fund-level transactions. As a result, compared to mutual funds that invest in similar assets, this has a lower cost of ownership and higher returns.
Instead of selling securities for cash, the ETF issuer can satisfy redemptions and portfolio rebalance in-kind (exchanging securities for ETF shares) in the ETF primary market.
This in-kind transaction does not result in a taxable event for the fund. It can protect fund shareholders from capital gains from other shareholders’ buying and selling decisions.
When an AP redeems ETF shares, the issuer does not immediately rush to sell ETF shares to pay the AP in cash. Instead, he’s paid “in-kind” by delivering the ETF’s underlying assets.
No capital gains, therefore. Additionally, the ETF provider selects the stocks to be given to the AP, making sure that the shares with the lowest tax liability are given to the AP.
This leaves the ETF issuer with only shares acquired at or even above the market rate, lowering the fund’s tax burden and, as a result, providing investors with better after-tax returns.
For some ETFs, the mechanism does not augur well. Fixed-income ETFs are less tax-efficient than other ETFs due to higher turnover and recurrent cash-based creations and redemptions.
That said, ETFs win hands down, with two decades of evidence pointing out their high tax savings compared to any other investment avenue.