ETFs Deliver on Their Tax-Efficiency Promise

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.  

Prospectus Benchmark ETF Name 5yr Gain Dist  10yr Gain Dist  15yr Gain Dist  OE Fund Count MSCI US Broad Mkt USD Vanguard Tot Mkt 0.00 NA NA     US OE Average Idx Fund 0.00 0.14 0.30 3 S&P Completion Vanguard Ext Mkt 0.00 NA NA     US OE Average Idx Fund 0.42 2.40 3.19 4 DJ Wilshire 5000 TR SPDR DJ Wil Tot 0.00 NA NA     US OE Average Idx Fund 0.34 0.00 0.00 6 Dow Jones Stoxx 50 Idx SPDR DJ STOXX 50 0.20 NA NA     US OE Average Idx Fund 0.91 0.00 0.00 2 MSCI EAFE USD iShares MSCI EAFE 0.00 NA NA     US OE Average Idx Fund 2.04 3.04 3.54 13 Russell 1000 Gr TR USD iShares Rus 1000 Gr 0.00 NA NA     US OE Average Idx Fund 1.54 0.00 0.00 3 Russell 1000 Val TR USD iShares Rus 1000 Val 0.00 NA NA     US OE Average Idx Fund 3.98 0.00 0.00 3 Russell 2000 Gr TR USD iShares Rus 2000 Gr 0.00 NA NA     US OE Average Idx Fund 6.39 0.00 0.00 2 Russell 2000 Val TR USD iShares Rus 2000 Val 0.00 NA NA     US OE Average Idx Fund 7.79 0.00 0.00 2 Russell Mid Gr TR USD iShares Rus Mid Gr 0.00 NA NA     US OE Average Idx Fund 5.28 0.00 0.00 2 Russell Mid Val TR USD iShares Rus Mid Val 0.00 NA NA     US OE Average Idx Fund 5.55 0.00 0.00 2 Russell Mid Cap TR USD iShares Rus Midcap 0.00 NA NA     US OE Average Idx Fund 4.53 0.00 0.00 2 Russell 1000 TR USD iShares Rus 1000 0.00 NA NA     US OE Average Idx Fund 0.00 0.00 0.00 4 Russell 2000 TR USD iShares Rus 2000 0.00 NA NA     US OE Average Idx Fund 4.78 4.38 3.74 32 Russell 3000 TR USD iShares Rus 3000 0.00 NA NA     US OE Average Idx Fund 2.12 0.00 0.00 1 DJ Industrial Avg TR USD DIAMONDS Tr, Ser 1 0.00 0.00 NA     US OE Average Idx Fund 0.15 0.00 0.00 2 S&P 500 TR SPDRs 0.00 0.00 0.01     iShares S&P 500 0.00 NA NA     US OE Average Idx Fund 1.03 1.05 1.61 171 NASDAQ Comp TR USD Fidelity Nasdaq 0.14 NA NA     US OE Average Idx Fund 0.63 0.00 0.00 1 S&P 500/Citi Gr TR iShares S&P 500 Gr 0.00 NA NA     US OE Average Idx Fund 0.73 0.00 0.00 2 S&P 500/Citi Val TR iShares S&P 500 Val 0.00 NA NA     US OE Average Idx Fund 2.10 0.00 0.00 2 S&P Mid 400/Citi Gr TR iShares S&P 400 Gr 0.00 NA NA     US OE Average Idx Fund 1.64 0.00 0.00 2 S&P Mid 400/Citi Val TR iShares S&P 400 Val 0.00 NA NA     US OE Average Idx Fund 1.57 0.00 0.00 2 S&P Sm 600/Citi Gr TR iShares S&P 600 Gr 0.00 NA NA     US OE Average Idx Fund 1.31 0.00 0.00 2 S&P Sm 600/Citi Val TR iShares S&P 600 Val 0.00 NA NA     US OE Average Idx Fund 0.56 0.00 0.00 2 S&P 100 TR iShares S&P 100 0.00 NA NA     US OE Average Idx Fund 0.54 0.55 1.28 3 S&P MidCap 400 TR MidCap SPDRs 0.00 0.24 NA     iShares S&P 400 0.00 NA NA     US OE Average Idx Fund 4.90 5.93 5.17 34 S&P Sm 600 TR iShares S&P 600 0.00 NA NA     US OE Average Idx Fund 7.79 6.43 7.44 20
 

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.

Shocking Results
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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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.