ETF tax efficiency revisited as fund distributions loom

The end of 2019 is rapidly approaching, which means many investors and financial professionals are considering which tax-friendly portfolio moves to make before December 31. Part of year-end planning includes paying taxes on mutual fund capital gains distributions, and fund firms are gearing up to release estimates of distributions for the year.

Some experts are already warning this could be a big year for distributions¹ based on current trends in the equity markets and mutual funds, which could put a renewed focus on the tax efficiency of exchange-traded funds (ETFs).

When deciding between a mutual fund or ETF, we think the answer depends on the investor’s specific goals, time horizon, tax situation, and other factors. That’s one reason why it’s important to understand why ETFs are tax efficient and how they differ from mutual funds.

In coming weeks, mutual funds will estimate their 2019 capital gains distributions, and investors will be on the hook to pay taxes on those gains if their funds are held in a taxable account. With the S&P 500 Index up about 17% so far this year² and many global equity markets also rising, some funds may distribute significant gains.

Yet, funds can still make distributions even if they’re down for the year. Take 2018, a year in which the S&P 500 Index lost 4.4% on a total-return basis.³ Last year, 91% of all U.S. equity funds posted a negative return, yet 86% of these funds had a capital gain distribution. And among those that paid a distribution, the average distribution was 11%, which was the highest in nearly three decades.⁴

There are two main reasons why many U.S. equity funds distributed gains in 2018 despite a negative year for the S&P 500 Index.

First, many active equity funds have experienced net redemptions in recent years. Significant outflows may force the portfolio manager to sell appreciated stock positions to raise cash to meet the redemptions. And those transactions can trigger a distribution for the smaller base of shareholders left remaining in the fund. Fund shareholders can be hit with a distribution even if they didn’t sell the fund, portfolio turnover was low, and the fund was in the red for the year.

The second factor is simply that the length of stocks’ recovery from the 2009 bottom means many funds are holding appreciated stock, and also don’t have losses they can tap to offset gains that must be distributed to shareholders.

The structure of ETFs and how they trade generally makes them more tax efficient than mutual funds. Just 7.5% of all U.S.-listed ETFs paid a taxable capital gain distribution in 2018.⁵ Just remember that while ETFs are generally more tax efficient than mutual funds, that doesn’t mean they’re immune to paying out capital gain distributions.

So what exactly makes ETFs tax efficient?

First, most equity ETFs are passively managed and track indexes, which helps keep turnover lower than most actively managed funds. However, the structure of ETFs is what really makes them tax efficient. Specifically, how they trade on exchanges, and how shares are created and redeemed.

Typically, when a mutual fund experiences net redemptions, it has to sell securities to raise cash to give back to investors. This can result in a capital gain for the fund that must be distributed to shareholders.

ETFs, on the other hand, are bought and sold on the exchange, so investors typically don’t interact directly with the ETF. And during supply/demand mismatches, authorized participants (APs) can create and redeem large blocks of shares of the ETF “in kind,” which can avoid cash transactions and taxable events. The ETF issuer can further reduce the tax burden by transferring shares to APs bought at lower prices and keeping those bought at or above current market prices, which may also generate higher returns after tax.⁶   

The bottom line for year-end planning is that another big round of mutual fund capital gains distributions may cause more investors to at least consider more tax-efficient strategies and structures such as ETFs.

1 "An Early Warning on Capital Gains Tax Distributions,” Morningstar.com, 9/17/19. 2 S&P Dow Jones Indices, as of 10/1/19. 3 S&P Dow Jones Indices, as of 12/31/18. 4 “Repeat after me – Ouch. Ouch!. OUCH!” Russell Investments, 4/15/19. 5 “ETFs Are Tax Efficient, but Is That Sound Policy?” Morningstar.com, 2/28/19. 6 There can be no assurance that active trading markets for the shares will develop or be maintained by market makers or authorized participants, and there are no obligations of market makers to make a market in the fund’s shares or to submit purchase or redemption orders for creation units. Although market makers will generally take advantage of differences between the NAV and the trading price of fund shares through arbitrage opportunities, there is no guarantee that they will do so. Decisions by market makers or authorized participants to reduce their role with respect to market making or creation/redemption activities in times of market stress could inhibit the effectiveness of the arbitrage process in maintaining the relationship between the underlying value of the fund’s portfolio securities and the fund’s market price. This reduced effectiveness could result in shares trading at a discount to NAV and also in greater-than-normal intraday bid/ask spreads for shares.