ETFs can be a good choice for tax-sensitive investors, but remember they aren’t tax-exempt.
A version of this article was published in the November 2015 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor by visiting the website.
Exchange-traded funds are often lauded for their superior tax efficiency. But are they really unique from their index mutual fund brethren in this respect? What are the underpinnings of ETFs’ tax advantages? Here, I’ll cover the sources of that tax efficiency in detail and share data that lays bare why it is such an important feature for tax-sensitive investors.
ETFs’ tax efficiency has two sources. The first stems from strategy, the second from structure. The first and most important factor explaining ETFs’ tax efficiency is the fact that index-tracking funds (where 99% of ETF assets are located) generally have far lower turnover relative to actively managed ones. The natural rate of turnover for a broad, market-cap-weighted U.S. stock index fund is 3%–5% per year.
In the table below, I’ve calculated the median annual turnover for all share classes of actively managed mutual funds and index-tracking ETFs in the U.S. large-blend Morningstar Category over the past 10 years. It is immediately evident that index-tracking ETFs turn their portfolios over at a fraction of the rate their actively managed mutual fund peers do. This is only natural, given that most of the ETFs in this sample simply own the market. Any changes in the composition of these funds’ portfolios will be driven by index changes, which in turn are a result of normal index rebalancing, reconstitution, and corporate actions (such as mergers and acquisitions). Less buying and selling results in fewer taxable events—it’s really that straightforward.
It’s important to emphasize that this source of tax efficiency is strategy-specific and has nothing to do with the ETF structure. Index mutual funds in the large-blend category have experienced similarly low levels of turnover over the past decade. This should come as little surprise given that many of them track the same indexes that underlie their ETF peers.
Passive, low-turnover strategies are the linchpin of ETFs’ tax efficiency.
The second source of ETFs’ tax efficiency is the in-kind creation and redemption mechanism by which ETF shares are brought into and removed from the market. The differences between how ETF shares and mutual fund shares are created and destroyed have important implications for investors in each wrapper.