ETF versus index fund: which is more tax effective?

--  |   15/08/2019 Text size  Decrease  Increase   |  
email_fwd
<p><strong>Christine Benz</strong>: 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.</p> <p>Ben, thank you so much for being here.</p> <p><strong>Ben Johnson</strong>: Thanks for having me, Christine.</p> <p><strong>Benz</strong>: 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?</p> <p><strong>Johnson</strong>: 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.</p> <p><strong>Benz</strong>: 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?</p> <p><strong>Johnson</strong>: Exactly.</p> <p><strong>Benz</strong>: 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&hellip;</p> <p><strong>Johnson</strong>: That's right.</p> <p><strong>Benz</strong>: &hellip;that someone might use. What were the headline conclusions?</p> <p><strong>Johnson</strong>: 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.</p> <p>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 behaviour 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 behaviour of those around you, which might not necessarily be bad behaviour, 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.</p> <p>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.</p> <p><strong>Benz</strong>: The traditional index funds that have been making those big distributions, those aren't the big widely held index funds, correct?</p> <p><strong>Johnson</strong>: No, absolutely not. So, these large taxable cap gains distributions have been centred 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.</p> <p><strong>Benz</strong>: 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 favour 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.</p> <p><strong>Johnson</strong>: 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 are no cap gains that will be realised in most instances.</p> <p>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--</p> <p><strong>Benz</strong>: Right--</p> <p><strong>Johnson</strong>: --liquidating that portfolio--</p> <p><strong>Benz</strong>: Of securities--</p> <p><strong>Johnson</strong>: --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.</p> <p><strong>Benz</strong>: 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?</p> <p><strong>Johnson</strong>: Well, I'll say the answer is, it depends.</p> <p><strong>Benz</strong>: Okay.</p> <p><strong>Johnson</strong>: 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.</p> <p>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 are 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.</p> <p><strong>Benz</strong>: Okay. Ben, really interesting research. Thank you so much for being here.</p> <p><strong>Johnson</strong>: Thanks for having me.</p> <p><strong>Benz</strong>: Thanks for watching. I'm Christine Benz for Morningstar.</p>

Video Archive...

Lazard's 3 top picks for the energy transition
29/11/2021  These companies are set to profit from the move to clean energy, says Lazard.
An uneven energy transition leaves room for coal and gas: COP26 debrief
24/11/2021  The results of the COP26 climate summit suggest coal demand is likely to persist for longer than expected.
What rising inflation means for Australian investors
17/11/2021  And how investors can protect their portfolios.
6 inflation-tough stocks for global investors
08/11/2021  Morningstar thinks these moaty companies will remain resilient in the face of inflation and ongoing supply chain challenges.
Risk/reward equation still looks good at Westpac
05/11/2021  Morningstar maintains fair value despite a fall in margins and slower progress on cost reductions.
These aren't the Bitcoin ETFs you're looking for
19/10/2021  These new US-listed exchange-traded funds will invest in bitcoin futures, not bitcoin itself.
ESG funds don't underperform - but nor do they outperform
15/10/2021  The ESG outperformance narrative is flawed, new research shows.
Building investment portfolios in a low interest rate environment
06/10/2021  Investors may need to hold more growth assets over the coming years, says Morningstar's Jody Fitzgerald.
Covid impacts still being felt in real estate and tech: Reporting season roundup
01/10/2021  And how G8 Education and Link Administration are positioned for long-term success.
Look to Credit Corp for a leading indicator of economic health: Reporting season roundup
30/09/2021  What Reporting Season August 2021 told investors about the health of the financials sector.
Cause for optimism at a2 Milk and Invocare: Reporting season roundup
28/09/2021  a2 milk is an opportunity to be greedy when others are fearful.
Post-covid normalisation is underway in healthcare: Reporting season roundup
23/09/2021  Covid's winners and losers are returning to their prior trajectories. 
One of the most underappreciated dangers of investing
21/09/2021  Sequence-of-returns risk matters for both retirees and savers. Here's why. 
REITs recover pandemic losses: Reporting season roundup
20/09/2021  Analysts expect the sector to recover to pre-Covid trading levels once borders reopen.
Australian banks face margin pressure amid low rates: Reporting season roundup
15/09/2021  Rising customer deposits and access to cheap funding helped Australia's banks stave off net interest margin pressure, but analysts see warning signs.
Greenwashing explained
14/09/2021  Morningstar's Hortense Bioy on how to spot greenwashing and how to avoid it.
Earnings down as private money circles infrastructure: Reporting season roundup
13/09/2021  Utilities and infrastructure names battle the impact of covid as private equity and pension funds circle. 
Frenzy of mergers in energy: Reporting season roundup
10/09/2021  Hydrocarbons poised for a comeback.
TPG tipped to recover as mobile competition eases: Reporting season roundup
09/09/2021  Providers have lifted prices after years of a debilitating chase for subscribers at all costs , says Morningstar's Brian Han.
Short-sellers bet against ARK Innovation ETF
08/09/2021  What shorting ETFs means for long-term investors.
Surging lumber prices were no match for Brambles: Reporting season roundup
07/09/2021  Morningstar senior analyst Grant Slade says Brambles secular growth trend is intact despite nearterm headwinds. He discusses results from the building and construction materials sector.
Miners soar thanks to iron ore: Reporting season roundup
03/09/2021  Miners bask in the glow of iron ore prices while bargains remain in coal.
BHP-Woodside merger is mutually beneficial
23/08/2021  Post-merger Woodside would be well positioned to deliver on the value we've seen for a long time, say Morningstar analysts.
Investors are getting serious about sustainability
16/08/2021  But the sector lacks uniformity, says Morningstar's Christopher Franz. 
Long term outlook for AGL is positive
11/08/2021  Higher wholesale electricity prices bode well for AGL, according to Morningstar senior equities analyst Adrian Atkins.
How you can hedge your portfolio against inflation
11/08/2021  Morningstar FundInvestor editor Russ Kinnel describes some direct and indirect hedges for inflation protection.
The iron ore party can't last: Morningstar
10/08/2021  Copper and iron ore have benefited materially from China’s stimulus and the developed world recovery. But Morningstar analyst Mat Hodge see these benefit as transitory.
What the Afterpay acquisition means for investors: Morningstar Minute
05/08/2021  We believe the transaction has a high chance of succeeding.
Cannabis' federal legal status is not a total buzzkill
03/08/2021  The industry still has significant growth potential.
Stock of the week: Toyota
03/08/2021  Is one of the biggest sponsors of the Olympics positioned for an all-electric future?
2 listed microcap names to consider
23/07/2021  Morningstar's Lex Hall talks micro-cap stock picks with Carlos Gil, chief investment officer at Microequities Asset Management.
Big returns, big risks: Making money with microcaps
22/07/2021  Mornngstar's Lex Hall catches up with Carlos Gil, chief investment officer at Microequities Asset Management.
3 small-caps with Dawn Kanelleas
21/07/2021  The head of Australian small and mid-cap stocks at First Sentier Investors has her eye on ARB, Breville and IDP Education.
Forecast 2021–2022: A correction could be around the corner
20/07/2021  The strong performances of global stock markets in 2020–21 are unlikely to be repeated in the coming year says Morningstar's Peter Warnes.
'Overvalued' warnings grow as ASX 200 hits new high
12/07/2021  Morningstar equity analysts warn that equities remain overvalued despite Australia's strong economic recovery.
What to know about private equity
08/07/2021  Private equity is an exciting area for investors, with lots of hotly-tipped stocks. But there are risks to be aware of, says Pitchbook analyst Dylan Cox.
Lazard's 3 top picks for the global covid recovery
08/07/2021  Warryn Robertson is looking at French infrastructure, retail pharmacy and tax services.
Aussie banks $34bn surplus points to more shareholder dividends, buybacks
06/07/2021  Australia's largest banks have excess capital because they cut dividends, were more conservative on lending, divested assets and raised equity last year. Morningstar's Nathan Zaia thinks most of it should be returned to shareholders.
Weighing up the PEXA IPO
02/07/2021  PEXA burst onto the ASX this week in the biggest float since 2019. Morningstar's Gareth James gives his take on the company's future growth prospects.
Can the iron ore price keep rising?
30/06/2021  Iron ore prices have  been on a tear, boosting the profits of Australia's top miners.  How did we get here and is the only way up? Lex Hall sits down with Morningstar's Mat Hodge.
2 new stocks to watch
28/06/2021  Morningstar has recently initiated coverage of a food delivery app and a consumer finance product. 
'Strongest earnings season I've ever seen'
24/06/2021  Meeting the deluge of demand is the biggest task for US companies, says Bell Asset Management's Ned Bell.
Biotech beyond covid
22/06/2021  Are there still opportunities in the biotech sector now the covid-19 vaccine roll out is underway? We ask International Biotechnology Trust manager Ailsa Craig
Alibaba is still deeply undervalued
21/06/2021  Morningstar's director of Asia equity research is confident the e-commerce giant will bounce back.
Weighing up the Endeavour IPO
18/06/2021  A wide moat and attractive dividend potential are among the key takeaways of Woolworth's decision to demerge from the liquor and hospitality group.
'Then we got hit with the equivalent of a war'
15/06/2021  Lazard Asset Management's Warryn Robertson explains how companies in the Global Equity Franchise fund have adjusted to covid, and assesses the threat of rising inflation.
Understanding Magellan's active ETF strategy
11/06/2021  Magellan's Craig Wright tells Emma Rapaport why it is leading the charge in the active ETF arena and how its global equity product works.
3 off-the-radar small caps
10/06/2021  Callum Burns of ICE Investors explains his conviction in pharmaceutical distributor Ebos, PSC Insurance Group, and elite sports analytics provider Catapult.
Small cap gems and how to find them
09/06/2021  Callum Burns explains how ICE Investors identifies companies with original products and sticky customer bases.
Stock of the Week: Salesforce.com
08/06/2021  They’re building an empire.
3 oil stocks we still like
07/06/2021  A year ago the oil price went negative. How have oil giants handled the past 12 months and what's the outlook from here? Morningstar analyst Allen Good explains.
Considering crypto? Here's what to think about
04/06/2021  As the investment world goes crazy for crypto, Morningstar Investment Management's Dan Kemp explains what to consider before putting it in your portfolio
Why we like Wizz Air
03/06/2021  The airline sector is set to recover as international travel resumes. Morningstar analysts think Wizz Air offer the best opportunity among low-cost carriers.
3 global infrastructure picks
28/05/2021  4D Infrastructure's Sarah Shaw outlines the investment case for Spanish multinationals Cellnex, and Iberdrola, and the potential of Mexican airports.
Are crypto ETFs coming?
28/05/2021  The SEC continues to sort out its regulatory concerns.
Stock of the Week: Apple
27/05/2021  We’re raising our fair value as sales hit new highs—but investors need to put it in perspective, says Andrew Willis.
Opportunities in global infrastructure
25/05/2021  Covid-19 has enhanced rather than impeded the future for global infrastructure, says Sarah Shaw of 4D Infrastructure.
Tribeca's eye for Domain
24/05/2021  Tribeca's Jun Bei Liu also explains why she sees opportunity in sleep apnea specialist ResMed as well as Treasury Wine Estates.
Stocks for emerging markets
19/05/2021  American Century Investment's Patricia Ribeiro sees growth in Chinese battery technology, biologics, and building materials in Latin America.
2 stocks for the rise of the robots
18/05/2021  Robotics is a fast-growing area of tech, creating opportunities in medical, logistics and life sciences sectors and much more.
Square: Stock of the week
18/05/2021  Square's Bitcoin purchase is more marketing than operations
Tesla: Stock of the week
10/05/2021  If Elon Musk ends up delivering, we might need to raise our fair value to US$1500 a share.
Why Tribeca's so upbeat on stocks
07/05/2021  Banks and resources are poised to deliver dividends, and Treasury Wine Estates and BNPL are worth a look, says Jun Bei Liu of Tribeca's Alpha Plus long/short fund.
Looking for value in emerging markets
05/05/2021  Digital banking, ecommerce and 5G are among the key trends set for rapid growth, says Patricia Ribeiro of American Century Investments.
Cash slashed, Aussie equities up: Why Morningstar updates Model ETF portfolios
04/05/2021  Analysts have made changes to the fixed interest, property, cash and equity allocations of Morningstar's Model ETF Portfolios to take advantage of the current market environment. They've also refreshed some of the funds in the portfolio.
Investing basics: Explaining the disconnect between the stock market and the economy
30/04/2021  The stock market and the economy are not the same. Here's why.
Why deforestation matters for investors
23/04/2021  EARTH DAY 2021: Why should investors care about deforestation and how can it can be taken into account within an investment portfolio? 
The silent killer: How to prepare your portfolio for inflation
21/04/2021  Do investors need to worry about inflation, and how do you prep your portfolio to protect you from it? Morningstar Investment Management's Dan Kemp explains.
ESG investing is about more than feeling good: Morningstar equity research
20/04/2021  Values-based investing is ultimately up to the investor.
2 US wide-moat stocks to buy on a dip
16/04/2021  Amazon.com and ServiceNow are looking increasingly attractive.
Fidelity's Kate Howitt names her 3 top stocks for 2021
15/04/2021  Investment tips from Australian equities fund manager Kate Howitt.
Back to basics: What is income investing?
14/04/2021  What is income investing, why is it important and which investors should focus on it? Morningstar Investment Management's Dan Kemp has the answers.
Hunting for pockets of value in an overheated market: Morningstar
13/04/2021  Morningstar equity strategist Gareth James discusses the great value rotation, why he believes the Australian share market is overvalued and where opportunities still lie for hungry investors.
Vaccine rollout drives energy's rise
12/04/2021  But the sector's current tailwinds are likely unsustainable, so investors should prioritise high-quality businesses with stable balance sheets, says Morningstar's Dave Meats.
Finding value with Kate Howitt
08/04/2021  Kate Howitt oversees Fidelity’s Australian Opportunities fund. She discusses her investing approach, the outlook and where she sees value.
Investing for millennials
07/04/2021  Goldman Sachs's Laura Destribats talks about the millennial investment trend, and why tech and experiences are so important to this generation.
What if I want to buy Bitcoin?
06/04/2021  Remember that the returns on speculative assets like Bitcoin are high risk
EGG, SGF, ZBRA: Foraging for the unloved gems
01/04/2021  Steve Johnson explains why Forager Funds Management has bought and held Enero, SG Fleet and Zebra Technologies and why they're poised for further growth.
Why the 'covid spending economy' will flourish
30/03/2021  Forager's Steve Johnson explains why he's bullish on consumer spending, enterprise software companies, and why he has cashed in on big names like Uber.
Proteomics set for growth, says Kardinia
29/03/2021  Kristiaan Rehder explains why the West Australian biotech is among the top performers in the Bennelong Kardinia Capital Absolute Return Fund.
Should you be worried about inflation?
26/03/2021  And how to make inflation "personal."
Crypto what?
25/03/2021  The how, what, and why of cryptocurrency.
The long and short of an absolute return fund
24/03/2021  An absolute return fund aims to seek returns in all weather. Kristiaan Rehder from Bennelong Kardinia Capital explains how.
3 dividend-paying real estate stocks for your watchlist
23/03/2021  Diversified portfolios, strong balance sheets and healthy payouts. Grant Berry singles out three big contributors to the SG Hiscock Property Income Fund.
AREITs in the time of covid
22/03/2021  SG Hiscock's Grant Berry explains how real estate was affected by the pandemic, how property stocks coped, and the chase for income in an evolving retail landscape.
Have we reached peak video gaming?
19/03/2021  Video gaming has soared under lockdown, can this sector keep growing post-covid? Morningstar analyst Neil Macker takes a look.
Myer: five stars and poised for the rebound
18/03/2021  The retail giant's strong balance sheet will help it navigate the shift to online shopping and capitalise on the return to normal life, says Morningstar's Johannes Faul.
Deliveroo IPO: what you need to know
10/03/2021  Ahead of Deliveroo's IPO, Morningstar analyst Ioannis Pontikis looks at the outlook for the business, its valuation and concerns about gig workers.
2 stocks for the e-learning boom
08/03/2021  E-learning has become the norm for young students and university-goers across the world. Morningstar analyst Michael Field looks at whether the trend is here to stay. 
February Reporting Season Wrap Up with Peter Warnes: Webinar
04/03/2021  Special guest Peter Warnes, our head of equities research, joins the Morningstar Foundations of Investing Webinar series to give his unique take on February Reporting Season and answer subscriber questions.
One year after the market crash, through the ETF lens
03/03/2021  The growth and adoption of exchange-traded funds has only accelerated as a result of the latest market crisis.
Brighter picture for big four banks
01/03/2021  Morningstar's Nathan Zaia on the outlook for the banks, dividend payouts and the move by the Bank of Queensland to acquire ME Bank.
One year on: lessons learned from the 2020 bear market
25/02/2021  The biggest takeaway from that period is not to panic when the market tumbles.
What if...I want to buy a gold ETF?
23/02/2021  From ETFs backed by bullion to miners with more upside potential - here's how to get yourself some gold.
'Full return to normal in 2021'
23/02/2021  If the US is to stage a recovery by mid-year, it will need the consumer services sector to fire, says Morningstar's head of economic research Preston Caldwell.
Google, Facebook versus Aussie news stocks
19/02/2021  Morningstar's Brian Han weighs up News Corp's deal with Google and examines the effect of Facebook's decision to block content from Australian media outlets.
Global real estate as a store of value
18/02/2021  Quay Global Investors' Chris Bedingfield explains how self-storage, data centres and industrial property can offer diversification and growth.
Spotting the 'covid winners'
16/02/2021  Uniti Group and Nextdc are among the companies that SG Hiscock's Hamish Tadgell says have flourished during the pandemic.
The transition from hope to growth
15/02/2021  Hamish Tadgell of SG Hiscock explains the portfolio changes he’s made in a bid to capitalise on the shift.
The future of the US economy
10/02/2021  Which pandemic-related trends have already passed, and which ones might be around the corner?