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Why Are Certain ETFs Less Tax-Efficient?

In-kind transactions benefit most, but not all, ETFs.

Patricia Oey, 01/20/2012

Over the past decade, exchange-traded funds have proved to be more tax-efficient than mutual funds. However, this does not mean that ETFs are magical tax-avoidance vehicles that the IRS has blessed with supernatural traits. For example, ETFs do not prevent taxes on dividend and interest income. However, when dealing with capital gains, the claim of ETF superiority has thus far rung true.

Equity-based ETFs distribute capital gains less frequently than open-end mutual funds of both the actively managed and passive varieties. In the rare cases when ETFs do make capital gain distributions, they tend to be smaller than their open-end fund counterparts in the same asset class. Most of the tax efficiency of these equity ETFs comes from the fact that they are passive funds that track market-cap-weighted indexes, which result in much lower portfolio turnover relative to actively managed mutual funds.

The second reason for ETFs' tax efficiency is how the funds deal with fund outflows, or investor redemptions. When mutual funds have outflows, they have to sell holdings to generate cash and also pass on any realized capital gains to fund investors. When ETFs have outflows, they conduct an in-kind transaction, exchanging holdings for ETF shares, which are then "destroyed." ETFs can select the shares to exchange, which allows them to purge securities with embedded capital gains. Because these are in-kind transactions, and not cash transactions, capital gains are not realized.

It's not that mutual funds cannot legally conduct in-kind transactions; it is simply impractical in most cases. Because ETFs deal directly only with institutional-authorized participants, and not retail investors, they do not have to worry about generating and doling out cash.

ETFs can also opportunistically use cash transactions for securities with unrealized capital losses. These losses can be used to offset future capital gains. These cash transactions, while not as frequent as in-kind transactions, can be done as part of a redemption or during an index rebalance.

In this article, we will highlight which asset classes are not able to meet the aforementioned criteria and therefore are usually less tax-efficient. We will also discuss other issues that may drive capital gains distributions across asset classes. Investors should note that these tax issues are specific to funds held in taxable accounts--investors will be able to avoid most of these tax concerns by holding funds in tax-deferred accounts.

Bonds Mature, But Fixed-Income ETFs Don't
While most of the large, popular equity ETFs have never made capital gains distributions, fixed-income ETFs have at times made distributions, albeit very small ones. The reason for this is that fixed-income ETFs need to maintain a relatively consistent duration (a measure of interest-rate sensitivity), which requires managers to replace maturing bonds with longer-dated bonds. When bond markets are stable, fund managers are able to turn over the portfolio without incurring capital gains.

However, this is not the case when fixed-income securities rally. In 2011, for example, a strong performance in Treasuries was the main reason a number of fixed-income ETFs had capital gains distributions last year. Fixed-income ETFs are also different from equity ETFs in another way: Debt securities can be retired early for cash, forcing funds to realize and distribute capital gains. In 2010, many homeowners refinanced their mortgages because of record-low interest rates. As a result, fixed-income ETFs holding mortgage-backed securities were forced to sell these securities and realize distributable capital gains.

Patricia Oey is an ETF analyst at Morningstar.
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