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By Ben Johnson, CFA and Christine Benz | 12-02-2015 12:00 AM

Just How Tax-Efficient Are ETFs?

Strategy and structure make ETFs more tax-efficient than most actively managed funds, but they're not immune from taxation, says Morningstar's Ben Johnson.

Christine Benz: Hi, I'm Christine Benz for Mutual fund capital gains distribution season is upon us, and tax efficiency is top of mind for many investors. Joining me to discuss the topic of exchange-traded funds and tax efficiency is Ben Johnson--he is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, in a recent issue of Morningstar ETFInvestor, you took a look at the tax efficiency of ETFs, and you looked at a couple of specific measures. Let's start with capital gains distributions. The past couple of years have been especially bad for investors in actively managed funds where they have been getting these big distributions. How have ETFs stacked up from the standpoint of making big capital gains distributions?

Johnson: ETFs continue to fare very well on a relative basis. We're nearly seven years into a bull market that's growing long in the horns, and what we're seeing is that the frequency and the magnitude of capital gains distributions from U.S. equity mutual funds--many of which have been in redemption for years now--have been massive. Meanwhile, if you look at U.S. large-blend ETFs, what we see is that capital gains distributions have been few and far between. The ones we've seen have been fairly small in terms of their magnitude, and this has very important implications for investors who are looking for U.S. equity exposure in a taxable account, because what we see is that, over long periods of time, this tax headwind that's created by absorbing the impact of these capital gains distributions can have a very meaningful impact on their aftertax performance. And we capture that in our tax-cost ratios.

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