Just How Tax-Efficient Are ETFs?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Mutual fund capital gains distribution season is upon us, and tax efficiency is top of mind for many investors. Joining me to discuss the topic of exchange-traded funds and tax efficiency is Ben Johnson--he is director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, in a recent issue of Morningstar ETFInvestor, you took a look at the tax efficiency of ETFs, and you looked at a couple of specific measures. Let's start with capital gains distributions. The past couple of years have been especially bad for investors in actively managed funds where they have been getting these big distributions. How have ETFs stacked up from the standpoint of making big capital gains distributions?

Johnson: ETFs continue to fare very well on a relative basis. We're nearly seven years into a bull market that's growing long in the horns, and what we're seeing is that the frequency and the magnitude of capital gains distributions from U.S. equity mutual funds--many of which have been in redemption for years now--have been massive. Meanwhile, if you look at U.S. large-blend ETFs, what we see is that capital gains distributions have been few and far between. The ones we've seen have been fairly small in terms of their magnitude, and this has very important implications for investors who are looking for U.S. equity exposure in a taxable account, because what we see is that, over long periods of time, this tax headwind that's created by absorbing the impact of these capital gains distributions can have a very meaningful impact on their aftertax performance. And we capture that in our tax-cost ratios.

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Benz: I want to talk about the tax-cost ratio data, but before we go there, you mentioned the redemptions creating this issue with capital gains distributions. Can you quickly explain the connection there?

Johnson: Well, the redemptions are equivalent to selling: The investors' selling of the mutual fund causes selling activity at the level of the mutual fund. The portfolio manager has to go out and sell securities, many of which have appreciated since they purchased them, in order to facilitate investors' redemptions--their call for their cash back. In doing so, selling these individual stocks for a price greater than they purchased them for, they're unlocking those embedded taxable capital gains--which, in turn, they have to share with investors.

Benz: You mentioned tax-cost ratio. Let's talk about that data point--what it captures. Here, again, I'd like to look at how exchange-traded funds look from the standpoint of tax-cost ratios, relative to the universe of traditional mutual funds.

Johnson: The tax-cost ratio can be thought of as roughly equivalent to an expense ratio. But the expenses in question in this context are taxes--taxes on regular income distributions, taxes on capital gains distributions. So, you can interpret it in much the same way as you would an expense ratio. It's a hurdle or it's a headwind facing a fund--be it an actively managed one, be it an index fund. And what we see is that these tax-cost ratios, in the case of actively managed U.S. large-blend funds, have been persistently higher by a decent degree of magnitude relative to passively managed ETFs within the U.S. large-blend category. This is, again, incremental to what is already, in most cases, a pretty substantial fee hurdle that is faced by active managers.

Benz: Did you look at any other categories in addition to large blend? Was the tax advantage perhaps less for some of the other categories?

Johnson: There arecertain categories where you'll see the proposition of ETFs, from a tax-cost capital-gains-shielding point of view, diminish somewhat. Bonds are a perfect case in point. If you look at broad market-capitalization-weighted bond benchmarks--and particularly those that target a specific maturity bracket--what you see is that as bonds within those portfolios mature, if they mature at a price that is ultimately greater than what was paid for them, that maturation will unlock a taxable capital gain. Now, in those cases, we see a greater frequency amongst ETFs of capital gains distributions; but their magnitude tends to be quite small--and quite small, in particular, relative to what you might see within the context of an actively managed portfolio. So, that gap narrows somewhat, but it's still there. It's still fairly substantial.

Benz: Back to the equity funds: Let's talk about some of the features that tend to make ETFs more tax-efficient than, certainly, their actively managed counterparts.

Johnson: The two key sources of ETFs' tax efficiency are strategy and structure, I'd define it as. So, when we think about strategy, what I'm referring to is the fact that most ETFs, particularly within the U.S. large-blend category, track indexes that are very broad and they are market-capitalization weighted. So, the level of turnover in these benchmarks is anywhere between 3% and 5% a year. If you look at actively managed mutual funds within the U.S. large-blend Morningstar Category, run-rate turnover there can range between 50% and 70% per year. That greater level of activity yields greater potential to unlock taxable capital gains.

So, passive strategies are really the root--the foundation--of ETFs' tax efficiency because 99% of ETF assets are tied to indexes of some sort or another, relative to actively managed mutual funds. Now, that added increment I referred to earlier is structure. ETF structure is distinct from a traditional mutual fund structure. What I mean there specifically and what is most relevant is the way that investors' money moves into and out of a mutual fund relative to the way it moves into and out of an ETF.

A mutual fund tends to be a cash-in, cash-out proposition. I buy fund shares; I hand my money over to a portfolio manager; they buy securities and add them to the portfolio. I want my money back; they might have to sell securities and hand me cash back. That creates activity, which could yield taxable capital gains.

Benz: And it has recently, as you said.

Johnson: And has quite a bit recently. In the case of ETFs, it's not cash in, cash out--it's securities in, securities out. So, this in-kind creation and redemption mechanism that is unique to ETFs allows an ETF portfolio manager to push low-cost-basis securities--those securities that have appreciated quite a bit since they were first added to the portfolio--out of the portfolio in kind. So, it doesn't unlock any taxable capital gains, and it improves the overall efficiency above and beyond just that root, which is the strategy--which, in most cases, if you look at most ETFs and where most ETF investors' assets are invested, are in very broad, very low-turnover market-capitalization-weighted indexes.

Benz: I guess a follow-up question is--and I know a lot of investors grapple with this--traditional index fund versus ETF, if I'm holding this in a taxable account, what's the difference there?

Johnson: What we have there are two like strategies--they both follow passive strategies--

Benz: Low turnover.

Johnson: That added increment might add value; it might not. We're getting into an area now where if you look at either fees or if you look at tax costs comparing ETFs and index funds--especially those that track identical benchmarks--we're splitting hairs that may have already been split when trying to decide whether one might be more tax-efficient relative to another or whether the all-in cost of owning one might be greater than or less than the other, which frankly is a high-quality problem, I think, for investors to have--to be making decisions based on basis points. What we tend to see is that, really, the decision between those two vehicles now becomes more a matter of an investor's personal preference and his or her personal circumstance. Do they value the liquidity of the ETF wrapper? Are they already dollar-cost averaging into a mutual fund? It's going to vary on a case-by-case basis.

Benz: Final question for you, Ben: ETFs help shield you from those ongoing taxes--certainly capital gains distributions. They have done that so far, but ETFs aren't a panacea. If you have a taxable account, you still have tax considerations that the ETF strategy and structure don't fully control for.

Johnson: Two certainties in life: death and taxes. ETFs, by no means, do away with the latter. ETFs are tax-efficient, but they're not immune from taxation. So, ETF investors will still be on the hook for taxes on regular income; they will still pay capital gains taxes when they sell ETF shares for more than what they paid for them. So, the added benefit is that tax deferral that you gain by not having to pay capital gains taxes on a regular basis, as you might in the case of investing in an actively managed equity mutual fund or bond mutual fund. So, they're tax-efficient, yes, on a relative basis; but they're, by no means, immune from taxation.

Benz: Ben, it's an important topic. Thank you so much for being here to share your research.

Johnson: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.