Exchange-traded funds are generally touted as tax-efficient fund structures. In early November, Morningstar’s Christine Benz highlighted the largest estimated capital gains distributions among mutual funds in 2018. Most fund families have at least one mutual fund that’s expected to stick fundholders with capital gains distributions of more than 10% of the fund’s net asset value. Compared with actively managed mutual funds, ETFs are set to disburse fewer meaningful capital gains this year. Only two ETFs from the largest fund sponsors are expected to distribute capital gains distributions of greater than 10%. And most ETFs are not expected to distribute any capital gains.
Exchange-traded funds are generally tax-efficient vehicles for two reasons. First, ETFs usually pursue lower turnover strategies than actively managed mutual funds, which reduces realized capital gains, making capital gains distributions less likely. Exchange-traded funds can also harness structural advantages like in-kind transfers. This allows ETFs to meet redemptions by transferring (low-cost basis) shares from the portfolio to market-makers in a tax-free transaction. Mutual funds have to sell securities to raise cash to meet redemptions, which can generate taxable capital gains.
Adam McCullough, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.