The choice of “wrapper”—exchange-traded funds or managed funds choice—is no longer just a matter of preference; it is a critical lever for maximizing aftertax alpha.

The data from recent market cycles serves as a stark warning. In up years, like 2025, strong market returns forced many managed fund managers to realize gains to rebalance, resulting in widespread payouts. In 2025, roughly 72% of the US equity managed funds issued capital gains distributions, with average payouts ranging from 7% to 10% of the net asset value.

However, the “phantom” tax liability is even more damaging during down cycles. In 2022, the S&P 500 declined by over 18%, yet two-thirds of all US equity managed funds still distributed capital gains, averaging 7% of net asset value (“NAV”). This tax sting in a down year highlights a fundamental flaw in the managed fund structure: Investors are often forced to pay taxes on a losing investment.

Here are the four reasons why the ETF wrapper is the superior choice in 2026:

1. Structural mitigation of phantom tax liability

Managed funds suffer from an inherent “collective action” flaw: The behavior of your fellow investors dictates your tax bill. In both up and down markets, this creates a tax drag that erodes compounding. ETFs use the in-kind creation and redemption process. By exchanging baskets of underlying securities with market makers rather than selling for cash, the ETF manager can purge low-basis shares without a taxable event. Says Phil McInnis, chief investment strategist at Avantis Investors, “ETFs are far less likely to distribute capital gains, so it puts the control back in the advisor and client’s hands from a tax planning perspective.”

2. Lessons from the double-whammy years

History shows that managed fund distributions are often highest when investors can least afford them. For a $1 million portfolio, a 7% distribution in a down year (like 2022) results in a $70,000 taxable event. ETFs effectively eliminate this insult-to-injury scenario.

3. Enhanced operational transparency

In today’s sophisticated landscape, the lack of transparency is insufficient. Most ETFs provide daily transparency of holdings. This allows for precise risk monitoring, ensuring that a portfolio isn’t overconcentrating in high-risk sectors or closet indexing against a benchmark the client already owns.

4. Solving for the Cash Drag Problem

Managed funds typically maintain a cash cushion (often 3% to 5%) to handle daily redemptions. Because ETFs trade on the secondary market between investors, the fund manager can remain nearly 100% invested. Over a long-term horizon, reclaiming that 3% cash drag can translate to significantly higher compounded growth.