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Are ETFs Really More Tax-Efficient Than Mutual Funds?

In most cases, yes. But there are some interesting exceptions.

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Purveyors of exchange-traded funds hawk their wares as the cure for the common capital gains distribution. For a while, it was hard to assess the claim that ETFs are more tax-efficient than conventional mutual funds because few ETFs had significant track records. Now that more than a third of ETFs have been around for five years or more, we can assess if ETFs have delivered the tax efficiency they promised. Overall, the answer is yes. ETFs have been much more tax-efficient, as measured by Morningstar's tax-cost ratio, than the typical conventional mutual fund. A few exceptions, however, show that ETFs' tax advantage, while large, is not unassailable.

As tax-friendly as ETFs are, it also pays to compare their records with similar conventional mutual fund competitors. For instance,  Vanguard 500 Index's (VFINX) tax-cost ratios for the trailing one-, three-, and five-year periods ended Jan. 31, 2006, are lower than those of both of its ETF rivals:  SPDR (SPY) and  iShares S&P 500 Index (IVV). That means Vanguard shareholders lost less of their returns to taxes than investors in the ETFs. Vanguard 500's actual aftertax returns (assuming an investor doesn't sell the fund at the end of the time period) also are better than its exchange-traded rivals'. Similarly, at the end of January, the five-year tax-cost ratios and tax-adjusted returns of traditional index funds such as the  Schwab 1000 Index  (SNXFX) and the  TIAA-CREF Equity Index (TCEIX) were better than those of their ETF counterparts-- iShares Russell 1000 Index  (IWB) and  iShares Russell 3000 Index  (IWV), respectively. This shows traditional fund managers who pay attention to taxes--for example, by assiduously harvesting losses to offset gains--can be more than competitive with ETFs.

Before we examine the particulars, let's review why ETFs should be more tax-efficient than traditional mutual funds. ETFs are not immune from capital gains distributions; they may make them, for example, if the indexes they track change or if one company in a benchmark acquires another and pays a premium to do so.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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