Over 60% of equity mutual funds distributed capital gains in 2022. Adding insult to injury, their average return was negative 17% over that stretch. Investors saw their portfolios shrink significantly, and yet they still owed taxes.
By contrast, just 4.5% of equity exchange-traded funds distributed capital gains in 2022. ETFs have earned their reputation on tax efficiency. While investors will still need to pay taxes for dividends and interest regardless of investment vehicle, ETFs easily circumvent many of the capital gains distributions that plague mutual funds.
Leveraging ETFs’ tax efficiency to defer capital gains can ease tax bills today, but ETFs aren’t immune to taxes. Investors in ETFs will still be on the hook for capital gains taxes when they sell the ETF. From a tax perspective, their primary benefit is affording investors the flexibility to defer capital gains taxes.
Capital gains are realized at two levels: the investor and the fund. For investors, selling a holding at an appreciated price creates a capital gain. Choosing an ETF or mutual fund won’t avoid these capital gains. Funds also produce capital gains when they sell holdings at appreciated prices. Portfolio managers often attempt to avoid or offset gains when appropriate. But capital gains can be unavoidable under certain circ*mstances. That commonly occurs when funds sell holdings to meet cash redemptions, leaving capital gains for the remaining investors.
The Tax Advantage of ETFs
The process for creating and redeeming shares in a traditional mutual fund is straightforward. Investors give their cash to a fund company, and the fund managers use the cash to buy securities. The manager will often have to sell securities to raise cash to meet the redemption requests when the investor wants their money back.
The buying and selling, prompted by investors regularly entering and leaving a mutual fund, comes at a cost. Trading costs accumulate from brokerage commissions, crossing bid-ask spreads, and market impact—where the influx of momentary buy or sell requests causes prices to move temporarily, resulting in a “bad” price if the security’s price reverts after the order is filled. There is also an opportunity cost of holding cash to meet regular redemptions, which creates a drag on performance since that money isn’t invested. The final cost is the taxable capital gains distributions that result from a fund selling securities at appreciated prices.
ETFs are built to avoid the capital gains that result from turnover and redemptions. Investors buy or sell ETF shares on a stock exchange from other investors, not the fund. This avoids the need to raise cash to meet redemptions for small investors.
Investors buying and selling an ETF can push it away from its objective—often to track an index. ETFs’ in-kind creation/redemption mechanism allows the ETF to create/destroy shares to tightly track its bogy while avoiding the need to buy or sell holdings to meet investor flows. In-kind redemptions also allow ETFs to purge their portfolios of low-cost-basis securities by sending them out in kind while avoiding realizing gains.
A special set of investors known as authorized participants play an important role in this process. Only APs can create or redeem shares of an ETF. When creating shares, the onus to buy the requisite securities falls on the AP, who then exchanges them for ETF shares. When redeeming, APs trade in their ETF shares for a representative basket of the ETF’s holdings, again putting the burden on the AP to sell the underlying securities. In-kind transactions are therefore tax-free trades for ETFs: They don’t exchange cash for stocks. Consequently, the in-kind creation/redemption process doesn’t result in realized capital gains.
Contributors to Tax Efficiency
Capital gains and income aren’t taxed in tax-deferred accounts, like 401(k)s and IRAs. Some benefits of the ETF structure become moot in these types of accounts. For taxable accounts, income from dividends and interest create taxable events for mutual funds and ETFs alike.
Capital gains are the main difference between the tax profile of ETFs and mutual funds. ETFs can bypass taxable events using the in-kind redemption process, while also purging their portfolios of low-cost-basis securities to help portfolio managers avoid realizing large gains if they must sell holdings. But not all ETFs create and redeem shares in kind. The following are examples of ETF holdings that may not be able to be transferred in kind:
- Derivatives, such as swaps, futures contracts, currency forwards, and certain options contracts
- Physical commodities
- Securities domiciled in certain foreign countries that treat in-kind transactions as taxable events, the most relevant of which are Brazil, China A and B shares, India, South Korea, and Taiwan
Size also matters. Creations and redemptions typically occur in large blocks of 25,000 or more shares. This constrains smaller ETFs from using creations and redemptions to purge capital gains as often because there may not be enough trading activity to accumulate large blocks of shares.
Hunting Grounds for Tax Efficiency
When it comes to capital gains taxes, the first prerequisite are holdings that appreciate in price. Market segments with high price returns come with a higher capacity for capital gains. By contrast, a large portion of the tax burden for bond funds, for example, is tied to the income they throw off, which ETFs don’t quash. Therefore, choosing an ETF over a mutual fund for stocks is more critical to tax efficiency than choosing a bond ETF.
Exhibit 1 demonstrates that U.S. stock ETFs are prime territory for gaining tax efficiency. Foreign stock ETFs tend to be less tax-efficient than domestic ones. The inability to in-kind currency forwards and/or stocks from certain countries is part of the reason. But broadly diversified international equity strategies still benefit greatly from the ETF structure under many circ*mstances.
Choosing an ETF over a mutual fund can improve tax efficiency across each of the groups. But these are some areas where ETFs may not boost tax efficiency:
Commodities and Currency ETFs
Commodity and currency ETFs that are classified as limited partnerships typically hold futures contracts and are marked to market at the end of each year, passing gains through to investors. Gains are taxed annually, and the cost basis is adjusted to reflect the end-of-year value. The IRS treats gains from futures contracts as 60% long-term gain/40% short-term gain, so holding periods are irrelevant for these ETFs.
ETFs set up as grantor trusts give exposure to the spot market for commodities and currencies. For example, commodity grantor trusts physically hold precious metals in vaults. Investors may be shielded from marking to market, but these ETFs are considered “collectibles” by the IRS, meaning all gains are taxed as ordinary income.
Currency-Hedged ETFs
ETFs that hedge exchange risk do so using currency forwards. The U.S. dollar performed particularly well against foreign currencies in 2022, so currency-hedged ETFs were the largest source of capital gains distributions in the ETF market. Currency-hedged Japan strategies had huge gains from currency forwards thanks to a fast-appreciating dollar versus the yen. But there’s no opportunity to in-kind those gains out of portfolios, so investors were stuck with a big capital gains distribution and tax bill at the end of last year.
Single-Country ETFs
ETFs composed of stocks from a single country lose their tax efficiency if local tax laws don’t provide the same advantage for in-kind transactions. Taiwan and India ETFs were among the ETFs with the largest capital gains distributions in 2022.
Strategic Beta and Active ETFs With Small Asset Bases
Strategic beta and active ETFs, by definition, don’t employ market-cap weighting. They’re more susceptible to turnover when maintaining their intended strategy. Frequent buying and selling of holdings can cause the fund to realize capital gains, and these ETFs need substantial redemption activity to oust low-cost-basis holdings to make it easier to decrease and offset gains. It’s hard for APs or their market-maker customers to build a big enough position to meet the minimum creation/redemption basket size, therefore negating some of the ETFs’ tax advantage.
Tips for Avoiding Capital Gains Distributions
The ETF structure won’t hinder tax efficiency for investors. When in doubt, ETFs are probably a better option than mutual funds for tax-conscious investors. Strategies like those I outlined above, which fail to benefit from the efficiency of the ETF structure, are best held in tax-advantaged accounts with other high-income strategies. ETFs should be the vehicle of choice for taxable accounts.
The author or authors do not own shares in any securities mentioned in this article.Find out about Morningstar’s editorial policies.
