Exchange Traded Funds (ETFs) have been around for a while now and come in all different shapes and sizes. While many investors choose them for their diversification, low cost and intra-day trading flexibility, I believe the biggest single advantage of ETF’s may be tax-efficiency.
The largest tax benefits come from well-diversified index-like ETFs. Similar to index mutual funds, many ETFs have low turnover and as a result don’t typically pass capital gains distributions on to shareholders. If you have ever held a mutual fund that was at a loss for the year but then paid a big distribution that you had to pay taxes on, you know exactly what I’m talking about. It’s not fun! Generally, actively managed mutual funds can be inefficient due to a high turnover of securities in the portfolio. This is because capital gains realized by the fund are passed on to individual investors. Also, mutual funds must sell securities to raise cash if an investor wants to get out. This may force the gains on to the other remaining shareholders. Neither of these are issues for tax deferred accounts but they could be for regular taxable accounts.
When an individual investor wants to sell an ETF, it is simply sold to another investor similar to a stock on an exchange – with no capital gains occurring in the transaction. In order to handle investment inflows and outflows, an ETF manager delivers stock to create a basket of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any individual security. In less tax-efficient ETFs, such as emerging markets and commodity ETFs, there can be restrictions on delivering stock directly. Therefore, the fund may have to sell securities to raise cash for redemptions which would cause a taxable event and subject investors to capital gains.
Tax efficiency is not something many asset managers consider but capital gains distributions can easily amount to a few percentage points of an investment, so the tax saving of avoiding them can be significant!