Tax efficiency helps drive active ETF growth

An accelerating trend in the exchange-traded fund (ETF) market is the growing adoption of active and smart beta ETFs. The ETF wrapper, long known for providing liquid and transparent access to passive investment strategies tracking broad market indexes, is increasingly becoming the go-to structure for strategies that have the potential to outperform the broad market.

Last year, nearly two-thirds of ETF launches were active funds, the third year in a row favoring actively managed strategies. Nearly 15% of net flows went toward active ETFs in 2022, a trend that has accelerated this year, with almost 40% of flows now directed into active ETFs.

Smart beta ETFs have also seen growing interest from investors, gathering a record $94 billion, or nearly 16% of last year’s net flows into the structure. Smart beta (or strategic beta) ETFs use rules-based strategies to build portfolios that are designed to outperform a typical passive strategy. These ETFs lived up to their promise in 2022, with many performing well in the face of last year’s volatility due to their defensive nature. 

What's driving this trend?

In our view, there are two significant factors driving investor adoption of active and smart beta ETFs. First, many of these ETFs now have track records that span back several years, giving investors the ability to compare these ETFs directly against mutual funds and traditional market-cap-weighted ETFs.

As of the end of March, investors could choose from among 1,073 active ETFs currently available within the marketplace. Of these active ETFs, nearly a third have track records that span back for at least three years.

ETFs are more tax efficient

As more smart beta and active ETFs accumulate longer track records to support their performance, there’s another important benefit that helps these strategies outshine their mutual fund counterparts: their tax advantage.

This tax advantage is due to the ETF structure’s unique creation/redemption process. This process helps to potentially defer tax liabilities for ETF investors by relying on authorized participants (APs) to create and redeem large blocks of shares to meet demand. Since these shares are often created or redeemed in kind, it doesn’t create a taxable event. The process also allows for low cost basis shares to be transferred out, replaced by those with a higher cost basis, reducing the embedded gain.

This process helps ETF owners by limiting annual capital gains distributions: It doesn’t eliminate taxes, but rather defers the tax burden on individual investors until the time they sell their ETF shares. This stands in contrast to mutual funds, where larger redemptions might result in the remaining shareholders incurring that tax burden annually.

The efficacy of these tax strategies is evident, with the vast majority of ETFs eliminating capital gains distributions annually, allowing investors to prepare for and appropriately time their tax payments. Those who do pay out capital gains tend to have lower distributions than mutual funds, representing less than 1% of the average fund’s net asset value.  

Quantifying the tax benefit

So how much value can the ETF structure add for investors who hold these vehicles in taxable accounts? A recent study from the Wall Street Journal compared the after-tax returns of matched pairs of ETFs and mutual funds. The study accounted for fund family, investment objective, and cost structure to narrow in on the value added by the ETF wrapper’s increased tax efficiency. The results showed a measurable advantage for ETF after-tax returns.

Source: The Wall Street Journal, George Mason University, John Hancock Investment Management, 2/4/23.

The tax advantage varies but is present across asset classes, with international equity ETFs showing the largest advantage, outperforming the equivalent mutual fund by 0.33% on average. The benefit for fixed-income ETFs was much smaller, just 0.03%. 

A small advantage can grow over time

Although this return benefit seems small, measured in basis points, investors should note that these are annualized returns. Over a longer timeframe, this return advantage can compound, with the benefit snowballing as the years pass. For long-term investors who hold these funds in taxable accounts, opting for the more efficient ETF structure has the potential to significantly boost a portfolio’s value over time.

While not every mutual fund has an ETF equivalent currently available within the marketplace, we expect the active ETF market to continue to grow, providing investors with greater access to quality management teams in a more tax-efficient way.