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Indexing, Structure Help ETFs Win Tax Battle

Ben Johnson, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. As traditional mutual funds had another terrible year from the standpoint of taxable capital gains distributions, the case for owning ETFs, exchange-traded funds, in a taxable account grows. Joining me to discuss this topic is Ben Johnson. He is director of global ETF research with Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me.

Benz: In your recent issue of ETFInvestor, you took a closer look at this issue of tax efficiency and ETFs. You looked at data relative to traditional actively managed mutual funds. Let's just start by talking about what are the main reasons that exchange-traded funds tend to be more tax efficient than their mutual fund, especially actively managed mutual fund, counterparts?

Johnson: The first and perhaps the most important reason or source of ETFs' tax efficiency relative to active mutual funds owes to their underlying strategy. These are index funds, and in the case of, say, a total stock market index fund, what you see is that on a run rate basis the turnover of that index portfolio will be somewhere between 3% and 5% a year.

Now, if you were to move on to the active side of the ledger, what you see is that among active managers in a comparable category, so let's say the Morningstar U.S. large blend category, the median turnover among those managers is multiples more that of their index competitor. Turnover is what ultimately is going to beget or unlock capital gains that will then be distributed to fund shareholders. To the extent that the turnover of ETFs, by virtue of the fact that they are generally speaking tracking low turnover indexes is far, far lower, they have a distinct advantage relative to active funds. Now, that's part one.

Benz: And that's the biggest part?

Johnson: The biggest part.

Benz: And that confers an advantage to traditional index funds as well as ETFs. It's not just some ETF secret. Traditional index funds have low turnover too?

Johnson: Absolutely. So, when it comes to comparing, say, an S&P 500 index fund, a traditional index fund, versus an S&P 500 ETF, it could very well be a wash from a tax efficiency point of view. 

Now, the ETF itself, the second source of the advantage is the package. It's that it's an exchange-traded fund, and the way exchange-traded funds work is that new shares of exchange-traded funds are created, and unneeded shares of exchange-traded funds are destroyed via this so-called in-kind creation and redemption mechanism, whereby a market maker takes a basket of securities--say, the stocks in the S&P 500--delivers them to the ETF provider and receives shares of that ETF in return. When those shares are no longer needed, when there is excess supply in the market, the process works in reverse. That market maker comes back with the shares of the ETF and receives a basket of stocks from that portfolio.

This in-kind transaction, because there is no actual buying and selling at the level of the fund, forgoes or avoids unlocking any potential capital gains distributions. This is a unique advantage to the ETF structure. In the case of ETFs that are underpinned by indexes that have much higher turnover, we have seen a number of ETFs that have portfolio turnover of 300% to 400% a year that have been around for nearly a decade, that have never distributed a capital gain because of this novel structure.

Benz: You examined some data as I mentioned at the outset. Traditional mutual funds, active mutual funds especially, in part because we've had such a good equity market for so long, have been making some very large capital gains distributions in some cases to their shareholders. You examined active funds side-by-side with ETFs year by year. Let's talk about some of the main takeaways from that data.

Johnson: The key takeaway from that data is that the tax cost of owning actively managed mutual funds in a taxable setting is far greater than the tax cost of owning ETFs. That is owed almost exclusively to the differences in the cap gains distributions between each cohort. What we have seen is a bumper crop of cap gains distributions among active funds, given as you have alluded to the point we are at in the market cycle whereby these portfolios have seen tremendous appreciation, active managers in most instances have long since seen their well of capital losses all but dried up. So, they no longer have any way of shielding their investors from these gains, especially in the context of what has been a massive outflow from actively managed equity mutual funds. They have been facing redemptions all the while. It's been this sort of very much imperfect storm from the point of view of investors in many of these portfolios.

Benz: What are the exceptions that I should bear in mind? If I am looking at my taxable account and thinking about populating it with tax-efficient holdings, I guess I should first know that if I own anything that kicks off income, that it doesn't matter whether that income is coming from an ETF or a mutual fund. If I have income, I will owe taxes on it if I own it inside of a taxable account. Any other categories that I should be careful with, even though they are ETFs that they might not be so tax efficient.

Johnson: That first point is absolutely critical to understand is that if anything, ETFs are, to an extent, almost a tax-deferral arrangement in the regard that they will not distribute those cap gains in the majority of cases, that you can defer those until such a time you decide to liquidate your position in that particular fund. As you stated, you are still on the hook for taxes on any income distributions from these funds as you would be in the case of an actively managed mutual fund.

Now, ETFs' tax efficiency is not an airtight proposition. We have seen a number of cases over the years where ETFs have in some cases distributed some sizable capital gains. Common culprits in this category would be ETFs that use derivatives. What we've seen most notably in recent years is currency-hedged ETFs--ETFs that use forward contracts to eliminate or at least mitigate currency exposure in equity portfolios have realized gains on those contracts and have no way of in-kinding those contracts out of the portfolio. Thus, they have been somewhat less tax-efficient. Bond portfolios are another instance where bonds in a portfolio may mature, the cost of liquidating or otherwise the opportunity to purge those bonds from the portfolio prior to their maturity is just that. There it's cost prohibitive. Upon maturity, there may be a gain that's realized within those portfolios.

What we saw in 2017, which was interesting and somewhat new relative to what we've seen in years past, is there is a host of newer ETFs, ETFs that have been launched in the past three years or so, that were born into a bull market. These ETFs in many cases track more complex, higher turnover benchmarks and have seen nothing but inflows since their inception. Being born into a bull market, having a high degree of turnover, and having fewer redemptions, so fewer opportunities to purge the portfolio of lower-basis lots of stocks, has resulted in some capital gains among these newer ETFs as well.

Benz: And there could be more to come it sounds like?

Johnson: There could very well be more to come.

Benz: Interesting stuff. Thank you so much for being here to share your research.

Johnson: Thanks for having me.

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