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ETF or Traditional Index Fund: Which Is More Tax-Efficient?

Ben Johnson examines tax cost and tax efficiency by fund type.

Christine Benz: Hi, I'm Christine Benz for Morningstar. Investors have gravitated to exchange-traded funds for a variety of reasons, including tax efficiency. Joining me to share some research on the tax efficiency of various fund types is Ben Johnson. He's director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me, Christine.

Benz: Ben, let's talk about what we're talking about when we talk about tax efficiency. If I own a taxable account, it's just how much of a tax drag is on that account on an ongoing basis?

Johnson: That's exactly right. So, you can you can think of tax cost as just another headwind that is pressing against investors as they're trying to march down the path toward meeting their goals. And in the context of a taxable account, tax costs are real. They can be meaningful, and I think are most readily and most easily measured by our tax-cost ratio, which you can think of as almost an expense ratio of sorts. It's the levy that's taken by the taxman at the end of the day from your investment returns, which is inclusive of both taxes on normal income distributions, as well as capital gains distributions.

Benz: Okay. So, if I own a fund in a taxable account, that's where I'm concerned about tax efficiency, if I've got my holdings in an IRA or something like that, no need to worry about that?

Johnson: Exactly.

Benz: Okay. So, let's discuss the headline findings. You compared traditional passively managed funds, traditional actively managed funds, ETFs that are passively managed, as well as the smaller subset of actively managed ETFs. And you're looking at tax efficiency among those four wrappers…

Johnson: That's right.

Benz: …that someone might use. What were the headline conclusions?

Johnson: Well, what we see is that tax efficiency is really dependent on a number of different variables. One of those variables is just the turnover of the strategy in question irrespective of whether it's delivered through an open-ended mutual fund structure or an exchange-traded fund. So, lower turnover tends to lead to less potential for distributing taxable capital gains. If there's less regular buying and selling, there's less that's going to be unlocked as it pertains to cap gains distributions. So, lower turnover strategies of all types distributed across all vehicles will, all else equal, tend to be more tax-efficient versus their higher turnover peers.

Now, that said, you can't consider these variables in a vacuum. There are a number of other ones to take into account as well. Chief amongst those has to do with just the behavior of investors around you in the fund. Are they regularly coming and going, which itself can lead to higher or lower turnover? And ultimately, what we've seen is that even in the case of some very low turnover index mutual funds, which have witnessed massive outflows, there's no sheltering yourself from the negative externalities of the behavior of those around you, which might not necessarily be bad behavior, they might just be redeeming because they've saved, they've invested, they've met their goals, and now they have to take that money off the table to fund their retirement, for example. But that leads to, again, these negative consequences for ongoing shareholders in the fund.

So, in the case of open-end funds, we've seen a number of instances where very low turnover index mutual funds, that have been plagued by outflows, have distributed enormous taxable capital gains to their investors. Hopefully, many of those investors are not investing in those funds in a taxable setting.

Benz: The traditional index funds that have been making those big distributions, those aren't the big widely held index funds, correct?

Johnson: No, absolutely not. So, these large taxable cap gains distributions have been centered around much smaller funds, funds that have been plagued by outflows in recent years in the midst of a bull market. What we've seen amongst the larger, more widely held index funds is that they've been unaffected--generally because they've been in net inflows during that same period.

Benz: Okay. So, it sounds like one conclusion is, if I have a taxable account, and I'm trying to manage it for optimal tax efficiency, I should favor the ETF, even over the traditional index mutual fund, even though the latter have been pretty tax-efficient themselves. Let's talk about kind of the structural advantages that you think will continue to accrue good tax efficiency to ETFs versus traditional index funds.

Johnson: So, the structural advantage that ETFs have over open-ended mutual funds is, in some ways, I would say, a misnomer because many of the mechanics in the background are available to managers, sponsors of open-ended mutual funds. They just tend to use one specific route to meeting redemptions less relative to ETFs. And that has to do with the way that money specifically leaves the fund. So, ETFs benefit from an in-kind creation and redemption mechanism, which involves bringing stocks or bonds wholesale into the portfolio, and depositing in that portfolio, creating new ETF shares to be bought and sold on the secondary market. And the reverse of that process, when there are too many shares, when the supply of shares trading on the stock exchange is in excess of the demand for those shares. When that happens, shares are destroyed by removing those securities from the portfolio and delivering them out in kind. There's no actual sale. There's no cap gains that will be realized in most instances.

Now, mutual funds have that same ability, but shares of mutual funds are sort of dealt in a direct transaction between the investor and the fund company. So, mutual funds have in the past done in-kind redemptions. But they can tend to really only do it in a specific size. So, typically, the minimum is $250,000. And there are a few investors who are going to want to have to deal with--

Benz: Right--

Johnson: --liquidating that portfolio--

Benz: Of securities--

Johnson: --A few thousand securities in the case of some broad-based index funds on their own. So, ETFs, because those shares trade in the secondary market tend to make far more regular use of their ability to redeem in-kind than do traditional mutual funds. And that really is the linchpin of their tax efficiency, the ability to lift securities out wholesale, not actually transact in them, which might involve unlocking some embedded gains.

Benz: Okay. So, we focused mainly on equity funds in this conversation. How about fixed-income investments? Am I better off choosing the bond ETF versus, say, the bond index fund or certainly the actively managed bond fund?

Johnson: Well, I'll say the answer is, it depends.

Benz: Okay.

Johnson: Because first and foremost, not all bond index funds are created equal, not all bond ETFs are created equal. And in some cases--notably, the case of Vanguard--the bond ETF is a share class of the bond mutual fund. So, the tax consequences are shared across investors in all share classes of that fund.

What you will see, generally speaking, is still that ability to lift bonds wholesale out of the portfolio when there is the demand for turnover in the portfolio. Does lend itself to a degree of incremental tax efficiency, the advantages is less pronounced. And one of the key factors that that drives turnover really has to do with the makeup of the underlying index, issuance patterns in that underlying marketplace, certain factors which might not necessarily be able to be sort of immunized or shielded using that mechanism in the same way that it's more readily used and has been used very successfully among equity funds.

Benz: Okay. Ben, really interesting research. Thank you so much for being here.

Johnson: Thanks for having me.

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