Have ETFs Remained Tax Efficient This Year?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Exchange-traded funds tend to be more tax-efficient than mutual funds because they generally distribute smaller and fewer capital gains. But that doesn't mean that ETFs are tax-immune. Joining me to discuss how the capital gains distribution season is looking for ETF investors this year is Ben Johnson. Ben is Morningstar's global director of ETF research.

Hi, thanks for being here today, Ben.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: Before we get into some of the specifics, let's take a step back and talk a little bit about what really makes ETFs in general more tax-efficient than mutual funds.

Johnson: Well, Susan, ETFs' tax efficiency is really rooted in their structure and the way specifically that money moves into and out of ETFs, which is in stark contrast as to how it moves into and out of traditional mutual funds. So, most investors are probably familiar with the cash in cash out proposition that is a standard open-ended mutual fund. I, as an investor who wants to invest in your mutual fund, will fork over cash. That cash will go to the fund. The fund will take in the cash. The portfolio manager will put that cash to work for me as a new investor in that fund, will invest in a variety of different securities, stocks, bonds, you name it. When I want my money back, I call up the mutual fund company again and say, "I need that money." I've got to fund whatever my goal was for that money, or I want to take my money up--I'm a dissatisfied customer--and move elsewhere with it. So, the portfolio manager has to go back to the market, has to liquidate those securities, and has to deliver that cash back over to me as an investor.

Now, there are costs involved in that cash-in/cash-out transaction when it comes to going into the market and transacting in those securities. There may be brokerage costs. There may be market impact coming out. What we've seen in recent years is one of the most prevalent, one of the most pernicious costs has been tax costs to taxable investors. So, the departure of many a shareholder from many an open-ended mutual fund has forced those managers to sell securities that have appreciated in price relative to their cost basis. And in the course of doing so, they're unlocking taxable capital gains that are not just the problem of those that are leaving the fund but people who are sitting tight and loyal fund shareholders.

Now, ETFs are structured differently as opposed to cash in/cash out. You've got some optionality. If you're a portfolio manager, specifically, you can bring securities into the fund on an in-kind basis, so you can work with a third party called an authorized participant, which is a special sort of class of market maker that picks up a basket of the portfolio of securities, delivers that to the asset manager, and in return gets new shares of that ETF to meet new demand from investors. When demand is lower than supply, there's too many ETF shares on the market, the process works in reverse. So, that authorized participant comes back with ETF shares and get securities in return. In that process, through in-kind creation and in-kind redemption--securities in, securities out--you're not creating any of these negative externalities, to borrow a term from economics, none of this friction, none of these nasty year-end tax surprises, at least not to the same extent, at least not with the same frequency as you see in open-ended mutual funds.

Dziubinski: Now that being said, ETFs can make capital gains distributions and sometimes do. What have we sort of seen this year from some of the asset managers from a distribution standpoint?

Johnson: That's exactly right, Susan. It's important, as you alluded to at the onset, not to equate ETFs' superior tax efficiency with tax impunity. So, income distributions, for example, are going to be taxed if you're investing in ETFs in a taxable setting, and ETFs are not immune from taxable capital gains distributions. We've seen that for years, and we see that again this year. That said, given all those structural advantages that I just described, what we see is that taxable capital gains distributions in ETFs tend to be less frequent and they tend to be smaller in magnitude relative to what we see in open-ended mutual funds, and that's thus far proving to be the case again in 2020. As of today, what we've seen is that nine of the 15 largest ETF sponsors have reported on what they expect from their funds in terms of taxable capital gains distributions. Collectively, those 15 firms have 789 ETFs, and just 55 of those, so about 7% give or take, are expected to pay out any taxable capital gains. And for the most part what we see is that among those 55 ETFs that are going to distribute taxable capital gains, they're going to be pretty small in the neighborhood of 0.02% to, call it, half a percent of their underlying net asset value.

Dziubinski: And is that about standard? Is this where it has been this time of year in past years?

Johnson: It's in line with trend. It's a shade higher actually if you look back to the past two years. So, in 2019 and 2018, roughly 5.5% of that same universe of funds paid out any form of taxable capital gains distribution. So, it's ticked up, but ever so slightly.

Dziubinski: And are there any particular factors that are driving the distributions this year?

Johnson: Part of the reason that we've seen this uptick is what's been going on in fixed-income markets. Of those 55 ETFs that are slated to distribute taxable capital gains this year, 49 of them are fixed-income ETFs. And there's really a confluence of factors that explains why those funds are going to be distributing gains. Part of it just has to do with the way that some of them are structured. So, they might own a very specific segment of the fixed-income market, say, intermediate-term bonds. And if I'm carving out that specific segment and I'm an index fund, that means that once an intermediate-term bond crosses the border between intermediate and short term, I have to liquidate that position. It's going to roll over into a different portfolio. And what we've seen in fixed-income markets is that generally this year rates have gone lower, which has pushed bond prices higher. So, many of those positions that are rolling out of, say, intermediate term and into short term are appreciated positions now. So, the portfolio manager is having to liquidate those absent any opportunity to purge them from the portfolio in kind and realizing gains in the process, which is the other issue that we see at play this year is that those opportunities to take those securities out of the portfolio on an in-kind basis have been fewer and further between.

This has been a boom year for bond ETFs. Thus far this year, we've seen record flows into fixed-income ETFs as a category, and when flows are all going one way, they're all going into these funds, that gives fewer opportunities to send securities that have low cost basis out the other end. So, this in-kind creation redemption is almost like a tax dialysis of sorts for fixed-income ETFs, for all ETF portfolios, and that requires kind of a regular cycle or regular churn in the form of not just inflows but also outflows, and those outflows are what creates the opportunity to get lower-basis securities out of the portfolio, new inflows then can add higher-basis securities into the portfolio and raise the overall cost basis of that particular ETF. So, as bond ETFs have been having a terrific year in terms of inflows, there's just been fewer opportunities to kick those low-cost tax lots out the door.

Dziubinski: Interesting. But it still sounds like, Ben, it's still terribly tax-efficient in general this year, even though there might be a slight uptick.

Johnson: That's absolutely the case. I wouldn't take what we've seen this year as any indication of some sort of a fatal structural flaw or some as scary breach in the tax efficiency proposition of the ETF as a vehicle. I think it's held really quite well, even in the case of fixed-income ETFs, where we've seen a slight uptick in gains--again, those distributions have been small. And just six equity ETFs have distributed or will distribute, based on what we've seen reported to date, any taxable capital gains. So, the tax proposition there from a taxable investor's point of view, I think, remains as solid as ever.

Dziubinski: That's great. Well, thank you so much for walking us through the landscape today, Ben. We appreciate your time.

Johnson: I'm happy to join. Thanks for having me, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.