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ETF Specialist

Why Are Certain ETFs Less Tax-Efficient?

In-kind transactions benefit most, but not all, ETFs.

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Over the past decade, exchange-traded funds have proved to be more tax-efficient than mutual funds. However, this does not mean that ETFs are magical tax-avoidance vehicles that the IRS has blessed with supernatural traits. For example, ETFs do not prevent taxes on dividend and interest income. However, when dealing with capital gains, the claim of ETF superiority has thus far rung true. 

Equity-based ETFs distribute capital gains less frequently than open-end mutual funds of both the actively managed and passive varieties. In the rare cases when ETFs do make capital gain distributions, they tend to be smaller than their open-end fund counterparts in the same asset class. Most of the tax efficiency of these equity ETFs comes from the fact that they are passive funds that track market-cap-weighted indexes, which result in much lower portfolio turnover relative to actively managed mutual funds.

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Patricia Oey does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.