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ETFs: tax-efficient not tax-immune

Ben Johnson  |  29 Mar 2018Text size  Decrease  Increase  |  
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One of ETFs' most primary advantages is their tax efficiency--especially as measured relative to actively managed mutual funds. ETFs’ tax efficiency has two sources. The first stems from strategy, the second from structure.

The first and most important factor explaining ETFs’ tax efficiency is the fact that index-tracking funds--given 99 per cent of ETF assets are in index-tracking funds--generally have far lower turnover relative to actively managed ones. The natural rate of annual turnover for a broad, market-cap-weighted US stock index fund is between 3 per cent and 5 per cent.

Fewer taxable events

In a calculation of the median annual turnover for actively managed mutual funds and ETFs in the U.S. large-blend Morningstar Category over the past 10 years, it is clear that index-tracking ETFs turn their portfolios over at a fraction of the rate of actively managed funds. This is only natural, given that most of the ETFs in this sample simply own the market.

Any changes in the composition of these funds’ portfolios will be driven by index changes, which in turn are a result of normal index rebalancing, reconstitution, and corporate actions (such as mergers and acquisitions). Less buying and selling results in fewer taxable event--it’s really that straightforward.

It’s important to emphasise that this source of tax efficiency is strategy-specific and has nothing to do with the ETF structure.

Passive, low-turnover strategies are the linchpin of many--but not all--ETFs’ tax efficiency.

Structure

The second source of ETFs’ tax efficiency is the in-kind creation and redemption mechanism. The differences between how ETF shares and mutual fund shares are created and destroyed have important implications for investors in each wrapper.

The creation and redemption process in a traditional mutual fund is quite straightforward. When investors want to buy a fund, they fork over their cash to the fund company in exchange for shares in that mutual fund. The portfolio manager then puts that money to work, buying assets on behalf of the fund.

When investors want their money back, they sell their shares. When investors sell, the fund may have to liquidate assets in order to raise cash to hand back to the investor. This regular buying and selling, which is prompted in part by investors regularly entering and leaving the fund, comes at a cost.

That cost has several different components:

  • Frictional cost of portfolio turnover, which comprises things like brokerage commissions, bid-ask spreads, and market impact.
  • Opportunity cost of holding cash to meet regular redemptions. Many managers will keep a cash stake in the portfolio so they won’t have to regularly sell securities to raise cash in order to facili¬tate redemptions. This can weigh on performance during bull markets, as many funds might not be fully invested.
  • Another very meaningful part of this cost equation (and the one that is germane to this discussion) is taxable capital gains distributions. As funds liquidate low-cost-basis securities to meet redemptions or to free up cash to invest in new securities they will often--particularly in the advanced stages of a bull market, as is the case today--realise sizable taxable capital gains, which are passed on to shareholders.

ETF market in two parts

The creation and redemption mechanism for ETFs is a completely different animal. The ETF market is split in two: There is a primary market for ETF shares and a secondary one. Most investors deal exclusively in the secondary market, trading ETF shares back and forth between one another on the stock exchange. But when supply and demand for ETF shares gets out of whack, actors from the primary market mobilise.

For example, if investors want more shares of an ETF than there are available in the market (that is, demand outstrips supply), that fund will trade at a premium to its net asset value. This sends a signal to authorised participant--a special breed of market makers--to create new ETF shares.

They do so by gathering a basket of securities, say all the stocks in the S&P 500, and handing those securities over to the ETF provider in exchange for new ETF shares. The authorised participant then sells these shares on the secondary market, bringing supply and demand back in line and collapsing the premium.

This same process works in reverse when supply outstrips demand. This “in-kind” creation and redemption process is what keeps the price of ETF shares so close to the value of the basket of assets in their portfolios.

This process also lends important benefits from a cost point of view. First, because the buying and selling of securities is essentially outsourced to the market-making community (they ultimately recoup those costs and then some as they collect bid-ask spreads), the costs of adding and deleting securities from the port¬folio are not borne by long-term shareholders; they are incurred by buyers and sellers of ETF shares in the secondary market. It also means that that there is no cash drag: The fund will be fully invested at all times.

And last, but certainly not least, the in-kind creation and redemption process allows ETF portfolio managers to purge low-cost-basis positions from their portfolios without unlocking capital gains. This makes ETFs, in general, a far more tax-efficient wrapper than mutual funds.

Tax-efficient, not tax-exempt

Tax efficiency should not be conflated with tax immunity. Investors in ETFs will still pay taxes on regular distributions of income, and they will be on the hook for capital gains taxes when they sell an ETF for more than they paid for it. Also, ETFs will distribute capital gains, though they tend to be less frequent and of lesser magnitude than those generated by their actively managed counterparts.

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Ben Johnson is director of passive funds research at Morningstar, based in Chicago.

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