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Untangling ETF Tax-Efficiency Myths

In-kind redemptions give ETFs an edge in tax efficiency, but other factors are bigger when comparing them with mutual funds.

Paul Justice and Samuel Lee, 04/07/2012

This article originally appeared in the April/May 2012 issue of MorningstarAdvisor magazine.  To subscribe, please call 1-800-384-4000.

Exchange-traded funds have been promoted as being especially tax-efficient. While broadly true, some investors mistake ETFs as being uniquely tax-efficient. In order to dispel some myths, we investigate the structure and tax-efficiency record of ETFs. We find that physically replicated ETFs with in-kind creation and redemptions tend to be more tax-efficient than their open-end counterparts, but the magnitude of the benefits pale in comparison to factors like expense ratios, tracking error, index methodology, and replication methods. We also take a critical look at iShares’ claims that Vanguard’s dual share-class structure imposes additional costs on ETF-class investors.

When Are ETFs Tax-Efficient?
To understand the tax-efficiency argument, it is helpful to compare and contrast a typical ETF with a typical mutual fund. Neither mutual funds nor exchange-traded funds pay any taxes on interest payments, dividends, or capital gains. Instead they “pass through” distributions to their shareholders on a prorated basis, which are then taxed according to each shareholder’s tax situation. As long as there are no flows in or out, a mutual fund and an ETF identical in every aspect (underlying structure, index, embedded cost basis, etc.) will distribute identical capital gains.

ETFs don’t shield dividend and interest income. The ETF’s edge in tax efficiency comes from liberal use of in-kind redemptions. When an ETF experiences redemptions, it can hand over a basket of the fund’s underlying securities instead of cash. It can also pick which shares to hand over, ridding itself of tax lots with the greatest embedded capital gains. Because the trade is conducted in-kind, no capital gains are realized. While mutual funds can and occasionally do engage in in-kind transfers to meet big redemptions, they usually just liquidate portfolio holdings and distribute the proceeds to meet withdrawals. This is a practical constraint and not a legal obligation. Mutual funds deal with the public, so it would be impractical (and infuriating) to meet all redemptions with in-kind distributions. ETFs deal directly with institutional authorized participants (not the general public) when handling fund flows; they do not have to worry about generating and doling out cash.

This does not mean an ETF can exclusively conduct in-kind trades and avoid realizing any capital gains. Whenever an ETF changes its composition (as opposed to its size), it must trade securities like any other mutual fund and realize capital gains and losses. With these facts in mind, there’s no surprise that really only two simple criteria predict how likely an ETF is to distribute capital gains.

Did it change its portfolio composition frequently? This is distinct from but closely related to whether it had high turnover. An ETF can experience significant inflows and outflows, driving up its turnover, without making a single taxable trade. Passive, market-cap-weighted ETFs pass this test with flying colors.

Did it have many opportunities to conduct in-kind redemptions? Strong performance and inflows can result in capital gains accumulating faster than they can be purged. Some ETFs cannot accommodate in-kind redemptions. ETFs tracking less-liquid markets, such as high-yield bonds and some emerging markets, and ones based on swaps or futures are prominent examples.

The Capital Gains Distribution Test
Equity and fixed-income ETFs distributed capital gains less frequently and on a smaller dollar-weighted basis than open-end mutual funds of both the actively managed and passive varieties. However, distributions fall most dramatically going from active management to passive for equity funds. We ran the numbers for all categories, but for brevity’s sake we reproduced the results of five-year dollar-weighted capital gains distributions for active and passive mutual funds and for ETFs. Active funds make hefty distributions; passive mutual funds make almost none; and ETFs completely have eliminated them. (Exhibit 1)

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