ETFs Deliver on Their Tax-Efficiency Promise
Even against open-end index funds, ETFs can't be beat for low-tax distributions.
One of the key reasons for someone to choose an ETF over an open-end fund is that ETFs are supposed to be more tax-efficient in terms of delivering low capital gains distributions. For long-term investors with funds in taxable accounts, capital gains distributions are a nuisance that can force you to have to sell some of your holdings to pay taxes if you don't have cash on hand to do so. Worse, these distributions may come at a time when your tax bracket is higher than it would be in your retirement. Every advisor worth his salt knows that managing these capital distributions is key to maximizing the return of a passive investing portfolio.
So Are ETFs Tax-Efficient?
To find the answer to that question, I asked Morningstar's Corporate Research Group to run a study comparing ETFs to the toughest competition we could find: open-end index funds. In the study we tabulated the capital gains distributions for equity-based ETFs across 27 broad-based indexes. We did this over five-year, 10-year, and 15-year periods. We then compared that to all the relevant open-end index funds that tracked the same benchmark, and aggregated those distributions. When reading the chart, 0.00 means that there were no capital gains distributions. A number, for example 1.06, means that 1.06% of the fund's or the average fund's NAV was paid in capital gains distributions during that time period. Finally, NA means that the fund didn't exist in that time period. Unfortunately, most ETFs are relatively young, so the longer periods are bereft of comparison data.
Back to the question at hand: Are ETFs Tax-Efficient? The answer is a resounding "YES." In the past five years, only two ETFs in our study made a capital gains distribution (Fidelity Nasdaq Composite Index Tracking (ONEQ) and SPDR DJ STOXX 50 (FEU).) Over the past 10-year period, only one ETF ( MidCap SPDRs (MDY)) made a capital gains distribution. Admittedly, there were only three ETFs with 10 years of history for the study.
That ETFs hadn't made any distributions is hardly surprising. We know that the internal arbitrage mechanism at the core of the ETF structure makes these funds super-tax efficient, almost by definition. The shock, however, came from just how much better ETFs were in terms of tax-efficiency versus their open-end fund counterparts. Twenty-five of the 27 open-end groups in our study made taxable distributions of some sort in the last five years. In several of the small-cap categories the distributions were greater than 5% of the fund's net asset value. Even the 171 S&P 500-tracking open-end funds that we compared against SPDRs (SPY) and iShares S&P 500 (IVV) made average distributions of over 1% in each of the three periods we studied. Even to an ETF guy like myself, I found that these spreads were remarkable.
Not All ETFs Are Tax-Efficient!
There are nearly 850 ETFs and ETNs out there and not all of them are as tax-efficient as this sample of broad-basket ETFs. We have written numerous pieces advising and warning about the tax implications of using ETF products that hold derivatives in their portfolios, most notably leveraged, inverse, and commodity themed ETFs. If you haven't read our article breaking down these nuanced tax situations, I highly recommend it. It may be semantics, but these funds actually are tax-efficient for what they are doing. It is simply that owning derivatives and trading your portfolio daily is not very tax-efficient in the first place. Remember, as far as the IRS is concerned, an ETF is "looked through" to its underlying holdings and you are taxed accordingly.
Still, in terms of tax-efficiency in a passive equity index, ETFs are the clear winners.
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Scott Burns does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.