How Tax Efficient Have ETFs Been in 2021?

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.

Thanks for being here, Ben.

Ben Johnson: Thanks for having me, Susan.

Dziubinski: Let's start out with a little bit of a primer on ETFs and taxes. Why do ETFs in general tend to be more tax-efficient than mutual funds?

Johnson: Well, the root of ETFs' tax efficiency really has everything to do with the way that money moves into, moves out of, and moves within ETF portfolios and how that's different from the way that that happens within open-ended mutual funds more often than not. So, open-ended mutual funds tend to be a cash-in cash-out proposition. I invest in the fund, fork over the cash to the firm, manager puts money to work until I want it back, and when I want it back, odds are that they're going to have to sell certain securities to meet that redemption request. And in that process, there are all these frictions, right? There are trading costs. And on the way out, what we've seen in recent years is that there can be tax costs because the markets have been moving upwards into the right, the managers have done everything that they can within reason to try to shield investors from the tax costs that result from selling securities that have appreciated relative to their costs. So, what happens when that money comes out is it unlocks taxable capital gains distributions, which have been many and have been very large in some cases in terms of their magnitude, especially among open-ended mutual funds that invest in U.S. stocks in recent years.

Now, ETFs are different to the extent that when money moves in, moves out and even how the portfolio tends to be managed and rebalanced is that that tends to be a securities-in, stocks and bonds, and securities-out proposition. So, that's a factor of what is called the in-kind creation and redemption mechanism. So, when new ETF shares are needed or wanted by investors, a special breed of market maker called an authorized participant collects those stocks or those bonds, hands them over to the ETF manager, they add those to the portfolio, create new shares, those shares go to the end investor, are traded in the market. When those shares are no longer needed, the reverse happens. The authorized participant goes out, buys the ETF shares, hands them back to the asset manager, and gets stocks and/or bonds--the underlying basket--in return. There's no cash changing hands in that transaction. And as a result, ETFs have tended to be much more tax-efficient by virtue of taking advantage of that regular in-kind creation and redemption versus what tends to be more often than not cash-in cash-out within open-ended mutual funds. So, the ETF takes all of those externalities that are created by the bad--I won't call it bad, but--behavior, let's call it, of investors in an open-ended mutual fund that become everybody else's problem irrespective of whether they're buying and selling, and they flip it inside out. They make it the problem of people who are buying and selling and sort of immunize ongoing shareholders in the ETF from some of those externalities, especially the tax costs.

Dziubinski: That being said, ETFs can and do make distributions. Let's talk a little bit about what you're expecting and what you're seeing so far in terms of ETF distributions in 2021.

Johnson: Yeah. So, ETF's tax efficiency, and I should stress from the point of view of capital gains distributions, right? So, ETFs, no different than traditional funds, will continue to throw off dividend income, coupon income from bonds. We're talking specifically to capital gains distributions here. It's not an airtight proposition. There is inevitably going to be some leakage. There tends to be leakage among ETFs that invest in bonds that might not be able to take advantage of those in-kind redemptions to get bonds out that may have appreciated in value before, say, they mature within the portfolio. So, that's why in many cases you oftentimes see that bond ETFs will feature prominently among those ETFs that are distributing taxable capital gains, though I should stress, they tend to be quite small. And indeed, based on those firms that have reported estimated capital gains distributions thus far this year, those being iShares, Vanguard, and Schwab, what we see is that bond ETFs feature prominently.

The other ETFs that will often feature prominently are equity ETFs that for whatever reason can't fully take advantage of that in-kind redemption mechanism. And there are certain markets, especially emerging markets, notably China, India, South Korea, where in-kind redemption is actually not possible. So, when stocks that a particular ETF owns in that market have appreciated are sold for whatever reason from that portfolio, what you can see is that those ETFs, and indeed we saw it last year with certain China ETFs, can spin off significant capital gains distributions because there's a wrench that's thrown in that mechanism by virtue of the fact that those markets will not allow those ETFs to redeem those stocks on an in-kind basis.

Dziubinski: Based on what you've seen so far this year, are there any factors that have led to us seeing more distributions, greater distributions this year, less distributions? Or is it about the same as we've seen historically with ETFs?

Johnson: Well, the data is limited to date. I would say, generally, what we've seen is very consistent with what we've seen in years past: that capital gains distributions among ETFs are much fewer and further between than what we're seeing for open-ended mutual funds. The ones that we are seeing are smaller in magnitude. But there have been exceptions. So, there's one interesting example from the Vanguard suite of ETFs. So, Vanguard International Dividend Appreciation ETF, VIGI is the ticker, is actually throwing a capital gain off this year that amounts to somewhere between 5% and 6% of the fund's net asset value, which is notable, especially given that Vanguard has generally had a good track record when it comes to minimizing gains in its ETF suite, and that has everything to do with some of the factors I described before. So, some of those stocks in that fund's portfolio were purged from the portfolio but couldn't be purged on an in-kind basis, and some of them were purged because it's a dividend-oriented portfolio that focuses on stocks' dividend track records. And what we saw coming out of the COVID crisis last year is that many of those dividend-payers, dividend-growers, were put in a tough spot and, in some cases, actually had to either suspend or cut their dividends. So, some of those stocks were removed for exactly those reasons, which is why you see this unique case here with VIGI, spinning off what in ETF terms is a pretty sizable capital gain in 2021.

Dziubinski: Then lastly, Ben, are there any particular parts of the market or ETFs in particular besides the Vanguard fund you've referred to that maybe have larger than historical distributions, either that they've announced or that we think might be coming based on something that's gone on?

Johnson: Well, it's difficult to say with any degree of certainty, but generally speaking, even higher turnover ETFs, no different than higher turnover mutual funds, will tend to feature for whatever reason among those that are distributing gains. Again, less frequent, less in magnitude, but nonetheless you can see these gains oftentimes, especially among newer ETFs that might also have higher turnover and have yet to have sufficient opportunities to see redemptions, which give those opportunities to get rid of low-cost basis shares. So, that two-way turnover, that churn in the shareholder base of ETFs, is actually quite healthy from a tax perspective because it creates more opportunities to get rid, again, of those low-cost tax lots, raise the overall cost basis of the fund's portfolio, and reduce the chances that the fund will distribute gains to shareholders in the future.

Dziubinski: That's interesting. Well, Ben, thank you so much for your time and your perspective today on ETFs and taxes in 2021. We appreciate it.

Johnson: It was great to be here, Susan. Thanks.

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

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