The tax difference between equities, managed funds and ETFs
Tax matters to total return outcomes, so should be a consideration when choosing investments.
Tax is one of the most consequential factors in the outcome you achieve. It’s a structural drag that compounds over time which makes it a critical part of the selection criteria for any investment product.
Two portfolios with identical pre-tax returns can deliver meaningfully different outcomes after tax. Exchange Traded Funds (ETFs), managed funds and direct equities can all provide exposure to the same underlying assets with meaningfully different tax outcomes.
One important consideration of any investment option is the timing of tax liabilities as this will meaningfully impact your outcome.
Common ground
Most Australian ETFs and unlisted managed funds are unit trusts. Trusts themselves do not pay tax but instead, taxable income is distributed to investors. These investors pay tax at their marginal tax rates.
These distributions include:
- Net income (interest, dividends, foreign income)
- Realised capital gains when changes are made to the underlying portfolio
- Franking credits
- Foreign tax offsets
What differs between the various structures is how and when the taxable components arise, and how much control investors have over their timing.
Direct equities are unique. They place tax control almost entirely in the hands of the investor.
Direct equities
From a tax perspective, direct ownership of equities offers the highest degree of control.
The ability to choose when capital gains tax is triggered is extremely helpful over long time horizons. Deferral allows your investment to compound untaxed which increases after-tax returns. Being able to select a tax advantageous time to sell can lower the total tax due.
Managed funds
Unlisted managed funds offer professional management and diversification. Unlike equities, most of the record keeping is taken off the investor’s plate. They do however, come with structural issues that can change tax outcomes.
If you are an investor who buys units in a managed fund right before end of Financial Year, you may receive a large taxable capital gain that you’ll have to cover even if the transaction occurred long before you invested.
Exchange-Traded Funds (ETFs)
ETFs sit between direct shares and unlisted managed funds. They have trust taxation but there are differences given ETFs trade on an exchange.
While ETFs are also unit trusts, their structure makes them more tax efficient than unlisted managed funds.
To facilitate trading on an exchange, ETFs partner with authorised participants who create and redeem ETF units using baskets of securities, instead of cash – this transaction is called ‘in kind’. This reduces capital gains for the funds as well as trading costs which makes them more tax efficient for investors.
However, tax efficiency will vary based on the type of ETF and its underlying assets.
ETF investors still receive distributions and must pay tax at the end of financial year it was distributed. Overall tax efficiency will vary based on the type of ETF, the mandate and the underlying assets.
A cautionary tale is the Global X FANG+ ETF (ASX:FANG) - a global innovation leaders ETF. The ETF is designed to offer investors exposure to highly traded next generation technology and tech-enabled companies. In 2021 it came under fire by investors, many of whom did not know when and how the fund rebalanced and the consequences.
The ETF targets an equal weighting of each stock. To maintain this equal weighting the ETF needs to rebalance the fund by selling down positions that have done well during that period to buy more of positions that relatively underperformed. Selling positions that have appreciated lead to distributed capital gains.
In 2021 surging markets led to a distribution of $2.14 per unit which significantly exceeded 2020’s distribution of 12 cents. Given the success of the tech sector in 2021 the fund had to bring those equal weightings back into line due to the rebalancing policy. This led to hefty tax consequences.
It is important for investors to be aware of the investments in their portfolio and how they are likely to behave during differing market conditions. This can help with tax and cashflow planning.
