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ETF Specialist

Little Tax Pain for ETF Investors This Year

ETFs' tax-efficient structure and generally lower turnover have helped the funds avoid the relatively large capital gains distributions experienced by open-end funds this year.

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Exchange-traded funds are generally touted as tax-efficient fund structures. In early November, Morningstar’s Christine Benz highlighted larger than normal estimated capital gains distributions among mutual funds in 2019, with many growth-oriented mutual funds dishing out sizable payouts. However, compared with last year, large distributions that account for more than 10% of funds' net asset values appear to be less widespread among large, widely held funds. Compared with actively managed mutual funds, fewer ETFs are set to disburse significant 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, most ETFs pursue lower turnover strategies than 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 usually must sell securities to raise cash to meet redemptions, which can generate taxable capital gains.

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