Q. Are ETFs more tax efficient than mutual funds?
A. The answer is yes, but not for the reason you might think.
A recent Morningstar research paper “Measuring ETFs’ Tax Efficiency Versus Mutual Funds“ finds that the overwhelming majority of ETFs (84%) track market-cap-weighted indexes, which means there’s relatively little turnover in the fund to trigger tax events in the first place, with a median turnover rate of just 17% (compared to 48% for the average active mutual fund).
However, non-cap-weighted strategic beta ETFs have a turnover rate of 47%, very similar to active mutual funds, while cap-weighted index mutual funds have a turnover rate of only 19% (similar to ETF index funds), which means in practice the turnover factor is less a function of ETFs in particular, and just that the majority of ETFs invest in a different (cap-weighted indexing) strategy than most mutual funds (which are still more actively managed).
The real driver of ETF tax efficiency is the structure by which it adds and removes securities held by the ETF, and the ability to “purge” low-cost-basis securities in-kind as part of the creation/redemption process for ETFs (thus why ETFs have a slightly more favorable tax profile than mutual funds even when tracking the same index, and why mutual funds are more prone to tax events when facing net outflows as compared to ETFs). However, it’s important to recognize that ETFs are not immune to tax events, not only because they still distribute any interest and dividends, but because ETFs can still face capital gains distributions (albeit not common).
A. The answer is yes, but not for the reason you might think.
A recent Morningstar research paper “Measuring ETFs’ Tax Efficiency Versus Mutual Funds“ finds that the overwhelming majority of ETFs (84%) track market-cap-weighted indexes, which means there’s relatively little turnover in the fund to trigger tax events in the first place, with a median turnover rate of just 17% (compared to 48% for the average active mutual fund).
However, non-cap-weighted strategic beta ETFs have a turnover rate of 47%, very similar to active mutual funds, while cap-weighted index mutual funds have a turnover rate of only 19% (similar to ETF index funds), which means in practice the turnover factor is less a function of ETFs in particular, and just that the majority of ETFs invest in a different (cap-weighted indexing) strategy than most mutual funds (which are still more actively managed).
The real driver of ETF tax efficiency is the structure by which it adds and removes securities held by the ETF, and the ability to “purge” low-cost-basis securities in-kind as part of the creation/redemption process for ETFs (thus why ETFs have a slightly more favorable tax profile than mutual funds even when tracking the same index, and why mutual funds are more prone to tax events when facing net outflows as compared to ETFs). However, it’s important to recognize that ETFs are not immune to tax events, not only because they still distribute any interest and dividends, but because ETFs can still face capital gains distributions (albeit not common).
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