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Are ETFs Really More Tax-Efficient Than Mutual Funds?

In most cases, yes. But there are some interesting exceptions.

Dan Culloton, 02/14/2006

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Purveyors of exchange-traded funds hawk their wares as the cure for the common capital gains distribution. For a while, it was hard to assess the claim that ETFs are more tax-efficient than conventional mutual funds because few ETFs had significant track records. Now that more than a third of ETFs have been around for five years or more, we can assess if ETFs have delivered the tax efficiency they promised. Overall, the answer is yes. ETFs have been much more tax-efficient, as measured by Morningstar's tax-cost ratio, than the typical conventional mutual fund. A few exceptions, however, show that ETFs' tax advantage, while large, is not unassailable.

As tax-friendly as ETFs are, it also pays to compare their records with similar conventional mutual fund competitors. For instance, the tax-cost ratios of Vanguard 500 Index VFINX for the trailing one-, three-, and five-year periods ended Jan. 31, 2006, are lower than those of both of its ETF rivals: SPDR SPY and iShares S&P 500 Index IVV. That means Vanguard shareholders lost less of their returns to taxes than investors in the ETFs. Vanguard 500's actual aftertax returns (assuming an investor doesn't sell the fund at the end of the time period) also are better than its exchange-traded rivals'.

Similarly, at the end of January, the five-year tax-cost ratios and tax-adjusted returns of traditional index funds such as the Schwab 1000 Index SNXFX and the TIAA-CREF Equity Index TCEIX were better than those of their ETF counterparts--iShares Russell 1000 Index IWB and iShares Russell 3000 Index IWV, respectively. This shows traditional fund managers who pay attention to taxes--for example, by assiduously harvesting losses to offset gains--can be more than competitive with ETFs.

Tax-Advantaged

Before we examine the particulars, let's review why ETFs should be more tax-efficient than traditional mutual funds. ETFs are not immune from capital gains distributions; they may make them, for example, if the indexes they track change or if one company in a benchmark acquires another and pays a premium to do so.

A variety of factors should make distributions rare, though: ETFs are currently all index funds, which for the most part have lower turnover than actively managed funds. This helps limit their realization of capital gains. ETF investors also trade shares among themselves, not with the fund, so ETF managers don't have to sell securities to pay off redeeming shareholders. Only large investors, known as authorized participants, deal directly with the funds, and ETFs can satisfy those redemptions by giving those large investors baskets of their underlying portfolios' stocks instead of cash. Finally, ETF managers also can use that in-kind redemption process to get rid of the stock shares with the biggest unrealized gains, thereby limiting the ETF's potential for distributing gains.

The system seems to work. Capital gains distributions have been rare in recent years at most ETF shops. Indeed, we looked at the tax-cost ratios (which measure how much a fund's annualized return is reduced by the taxes that an investor in the highest tax bracket would pay on distributions) of ETFs that have been around for at least five years. We found that in six of the nine diversified domestic-stock fund categories the average ETF had a lower five-year tax-cost ratio through the end of January 2006 than the typical conventional open-end mutual fund. ETFs showed the biggest advantages in the mid- and small-cap blend and growth squares of the style box, where high-turnover strategies that can generate a lot of capital gains are common among traditional funds. The exceptions were the large-cap categories, where the average traditional fund's tax-cost ratios (0.39% for large blend, 0.13% for large growth, and 0.69% for large value) were lower than those of the typical ETFs (respectively, 0.48%, 0.26%, and 0.73%). Lower expense ratios may be working against ETFs here, because, like regular funds, ETFs tap their income to pay expenses. Because large-cap ETF expense ratios are a fraction of those charged by the average conventional offering in the category, the ETFs had more income to distribute.

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