Index Funds and ETFs: Tax-Efficient, But Not Always

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JP Morgan Equity Index fund OGEAX, an S&P 500 index tracker, is estimating a 9% capital gains distribution in 2016, following on the heels of an even larger distribution in 2015. That's no doubt an unwelcome development for investors who had been counseled to use broad-market index funds in their taxable accounts, but it shouldn't come as a complete surprise. While many equity index funds and exchange-traded funds (especially those that are widely held) have historically been tax-efficient, they're not a foolproof way to avoid taxes until you yourself sell. Special events, such as sizable asset outflows, can trigger larger than expected capital gains payouts. Other funds, despite falling under the index/ETF umbrella, aren't tax-efficient in the first place because they generate lots of income and/or short-term capital gains.

Good Bones Before we get into some of the situations when index fund and ETFs are not particularly tax-friendly, let's quickly review why equity index funds and ETFs are often touted for their tax efficiency in the first place.

The central reason is that many equity index funds and ETFs are tracking benchmarks that have very low turnover. The S&P 500, for example, changes roughly 20--or 4%--of its holdings per year. Indexes, and index funds and ETFs, may use additional techniques to further drive down trading or otherwise reduce the impact of realized capital gains for their shareholders. For example, indexes may use "buffer zones" to limit securities from bouncing in and out of the benchmark, and index funds may sell high-cost-basis shares first to reduce taxable capital gains. With limited selling on an ongoing basis, that means such funds aren't realizing capital gains very frequently, so they don't have any gains to pass out to shareholders.

Exchange-traded funds have additional features that can add to their tax efficiency relative to plain-vanilla index funds. (Vanguard's index mutual fund/ETF pairs are the exception; they've tended to be equally tax-efficient because the ETFs are a share class of the funds.) In part that's because retail ETF investors trade with one another, rather than asking the fund company to serve as the go-between. Whereas investors in traditional funds can ask their fund companies for their money back whenever they want, which can require the fund to sell to raise the cash, the ETF owner sells his or her ETF shares to another investor. Thus, the securities in the portfolio aren't being liquidated each time the ETF trades.

The creation and redemption mechanism for ETF shares further improves tax efficiency, as discussed in this article. When large ETF owners (called authorized participants) redeem their shares with the issuer of the ETF, the ETF issuer can pay off the seller "in kind" with holdings of the securities in the portfolio. (Some emerging-markets restrict ETFs' ability to engage in these in-kind transfers, but in practice the tax efficiency of emerging-markets index funds and ETFs has been decent, as discussed here.) Not only does the ETF not have to sell anything to pay off the departing large investor, but it can use this mechanism to wash out low-cost-basis securities in its portfolio by prioritizing them for in-kind delivery.

Yet even as broad-market index funds and ETFs are investors' best mousetraps for capturing equity-market returns while reducing the drag of taxes, ETFs and index funds aren’t foolproof on the tax-efficiency front. Some of these issues are specific to traditional index funds (that is, index funds that aren't ETFs); others affect both index funds and ETFs.

That's not to suggest that active funds in the same situation will look any better from a tax-efficiency standpoint, but rather that investors should avoid funds in the following categories within their taxable accounts.

They're Beset by Big Redemptions: As noted above, sizable shareholder redemptions won't derail ETFs' tax efficiency. But big outflows do have the potential to force capital gains realization at traditional index funds, which don't have the same capital-gains avoidance mechanisms that ETFs do. That appears to have been the case at the aforementioned JP Morgan S&P 500 fund: Despite tracking an index with low turnover, the fund has seen a swell of redemptions as investors have likely flocked to lower-cost alternatives in recent years. Those redemptions have forced selling that has unlocked taxable capital gains. That, plus the tax burden associated with the fund's dividend distributions, has translated into a 4.3% tax-cost ratio over the past year.

They Pursue Income-Centric Strategies: At the risk of stating the obvious, ETFs or index mutual funds that focus on securities that kick off ordinary income--bonds or REIT funds, for example, have no inherent tax advantage over non-index funds. That's not to suggest they don't have other benefits--especially their often-low costs--but no specific tax benefit accrues to them.

Qualified dividends are on an equal footing with long-term capital gains when it comes to their taxation. But focusing on dividend-paying stocks can erode some of the tax efficiency that accrues to traditional equity index funds and ETFs. That's because, in contrast with non-dividend-focused funds and ETFs that can limit their capital gains realization, dividend-focused index products have no option to curtail the payment of dividends. Those payouts must flow through to shareholders and are taxed in the year in which they're received, whether they’re spent or reinvested. Case in point:

They Use Derivatives: Index funds and ETFs can also fail the tax-efficiency test if they use derivatives to obtain exposure to a given market segment--for example, they use swaps and futures to either short a market segment or magnify their exposure to it. Gains on these derivatives are typically taxed as 40% short-term and 60% long-term; short-term gains are tax-unfriendly because they're taxed at investors' ordinary income tax rates. Moreover, ETFs trafficking in derivatives cannot take advantage of the in-kind creation/redemption process that plain-vanilla index funds can, further crimping their tax efficiency. It's debatable that investors need derivatives-focused products in their portfolios at all, but to the extent that they own them, they're a better fit in a tax-deferred account.