Why ETF Tax Efficiency Makes Them Better Than Mutual Funds

One of the reasons ETFs have exploded in popularity recently is because ETFs are more tax efficient compared to mutual funds. Why are do ETFs have better tax efficiency, and when does this difference even matter?

One note before we get started:

To be clear, in the post below when we mention “capital gains” we are talking about the taxes that would be realized by the fund, not necessarily the investor. Capital gains that are realized by ETFs and Mutual Funds are passed through to investors (usually at the end of the year) in the form of short and long term capital gains.

An investor may still have a separate tax on long term or short term capital gains from any sale of the funds they make.

However, in this article we are speaking only to the capital gains recognized by the fund and then distributed to the fund’s investors. Capital gains from ETFs and Mutual funds are taxed the same. The difference is that mutual funds are likely to generate more capital gains for their investors than ETFs.

Why are ETFs More Tax Efficient?

ETFs have the potential to be more tax efficient than mutual funds because of the fundamental difference in how a mutual fund operates, and specifically how normal redemption requests (when investors want to sell) are managed by a mutual fund compared to an ETF.

I think the easiest way to show this is with an example:

Consider the impact just an ordinary individual investor, putting in a sell order for $100,000.

Tax Impact From Selling the Mutual Fund

Mutual fund shares do not trade on the secondary market, meaning the fund itself handles all trades. If I put in a sell order and you put in a buy order, you will not be able to simply buy my shares, like would happen if I was selling a stock or ETF on an exchange (the secondary market).

So, the portfolio managers of the mutual fund have to be sure the fund itself has the cash to pay the $100,000 redemption. This means that the mutual fund may have to sell assets to meet any redemption request.

If the mutual fund has to sell shares of any investment that has appreciated in value, the fund will recognize a taxable gain, either short term capital gain, or long term capital gain depending on how long the fund has held the investment.

These gains are distributed by the mutual fund at the end of the year to current shareholders. And year after year, mutual funds make these distributions to their shareholders. The history of a fund’s capital gain distributions can be found on the fund’s website, or on most financial websites.

For example, the historical distributions of the Ariel Fund as they appear on Morningstar is shown below:

Ariel Fund tax efficiency

Tax Impact From Selling the ETF

If I am selling $100,000 in shares of an ETF, the shares are likely just going to be sold on the secondary market to another investor or investors who are looking to buy.

This is very similar to if I was selling $100,000 in a specific company stock. If I sell $100,000 in Exxon Mobil stock, the company does not step in and buy the shares. Instead, another investor purchases the shares from my over an exchange.

By selling my $100,000, the portfolio managers of the ETF don’t have to do anything. The shares are already created, the assets in the fund don’t change – the fund managers probably have no idea I just made the sale!

Nothing in this transaction of me selling my shares to another investor on the secondary market triggers any additional taxes within the ETF.

That example showed how ETFs handle small trades very easily, creating little to no taxable gains for investors. But what about larger trades, or times when tens of millions of dollars is changing hands?

ETF Tax Efficiency – Creation Units

Let’s say a big institutional investor wants to trade $10 million in an ETF, and this trade requires shares of the ETF to be redeemed. ETFs have another advantage to help them avoid realizing capital gains in this situation as well.

ETFs can also trade in “Creation Units” as well as cash. You will see a paragraph similar to this in the prospectuses of many ETFs:

How do creation units work, and why does it make ETFs more tax efficient?

ETF Creation Units

Think of a creation unit as a basket of securities that are allocation in the same proportion of the investments that make up the holdings of an ETF.

For example, if you own $10 million in SPY (An S&P 500 index fund) today, you own about $635,000 (6.35%) in Microsoft stock, $632,000 (6.32%) in Microsoft stock, $392,000 (3.92%) in Amazon stock, etc. These amounts are in the same proportion of the many billions of dollars of assets in the fund:

SPY index fund top holdings

So, if an ETF was looking to redeem $10 million in shares, it needs to provide the seller with $10 million in assets for the shares. Now, this could be in cash. But if the fund needs to sell stock to raise that $10 million, it may recognize capital gains.

A mutual fund would have to do with, but ETFs have another option. Instead of providing the dealer with $10 million in cash, the ETF can provide them with $10 million in securities.

creation units are the key to ETF tax efficiency

These shares can be provided “in kind” to the dealer, which means the fund does not have to recognize any capital gains. In this example, you can see how this might save the ETF many hundreds of thousands of dollars in potential capital gains!

Examples of ETF Tax Efficiency

How does all of this play out in the real world? Can we actually notice a difference in tax efficient ETFs compared to mutual funds?

Many fund companies today offer both mutual funds, and ETFs that invest in the same investments. This has given us great real world examples to see the increased tax efficiency of ETFs compared to mutual funds.

All numbers below are listed as distributions as a % of the fund’s NAV (Net Asset Value):

Vanguard ETF Tax Efficiency

Vanguard is perhaps the most well known fund company today for individual investors. Here’s what Vanguard is currently estimating for 2021 capital gains distributions:

Vanguard Mutual Fund: (VMGRX) – Vanguard Mid-Cap Growth Mutual Fund: 25.19%!

That is a huge distribution for this year for a basic index fund! What about the ETF version?

Vanguard ETF: (VOT) – Vanguard Mid-Cap Growth ETF: 0%

A huge difference! What does this mean for an individual investor? If you have $100,000 invested in Vanguard’s Mid-Cap growth mutual fund, you would receive $25,190 in excess taxable distributions this year compared to if you used the ETF!

That is a huge added tax burden. Most of the $25,190 would be taxed at long term capital gains rates, 15% for most. That means about $3,780 in added taxes!

While this Vanguard example is the most striking from 2021 numbers I have seen, it is hardly the only one.

DFA – Dimensional Fund Advisors Tax Efficiency

For example: DFA Core Equity 2 ETF vs Mutual Fund:

For 2021, here’s what DFA (Dimensional Fund Advisors) is currently projecting for capital gains distributions:

DFA etf tax efficiency vs mutual funds

DFA’s mutual fund: (DFQTX) – DFA US Core Equity 2 Mutual Fund: 4.37%

DFA’s ETF: (DFAC) DFA US Core Equity 2 ETF: 0.37%

What does this mean for investors? An extra $4,000 in taxable capital gains for those who are invested through the mutual fund compared to the ETF.

Schwab ETF Tax Efficiency

For example: Schwab’s small cap mutual fund vs ETF:

For 2021, here’s what Schwab is currently estimating for capital gain distributions:

Schwab mutual fund tax vs ETFs

Schwab’s mutual fund: (SWSSX) – Schwab’s Small Cap US Equity Index Fund: 7%

Schwab’s ETF: (SCHA) -Schwab’s small cap US Equity Index Fund ETF: 0%

For an investor with $100,000, this is an extra $7,000 in taxable long term gains for an investor who uses the mutual fund compared to the ETF.

When Does This Matter?

In general, this difference will be larger for funds that follow more active strategies. If the underlying assets of a fund change regularly, the fund is more likely to recognize capital gains.

In theory, this is less important for basic index funds. Though, as we showed above with the Vanguard example, this certainly does not mean that index funds don’t generate capital gains!

So, if the investment you are looking at has higher turnover (perhaps some factor funds, growth funds, or short term bond funds as a few examples), look to see if ETFs are available that replicate that strategy.

There are a few other times a fund may generate large capital gains, such as if the fund is seeing large outflows.

Outflows refer to the assets of the fund shrinking. If a fund starts the year with $100 million in assets, and investors redeem a net of $20 million during the year, the fund is down to $80 million in assets, and saw outflows of $20 million.

This is a sure sign that the fund was having to sell assets, and has a much higher likelihood of generating capital gains.

Account Type Matters Too

Lastly, remember that this is only applicable for investments in certain types of investment accounts.

Capital gains are only immediately taxable for investments in a taxable brokerage account. So, if your investments are in a 401(k), IRA, or Roth IRA this ETF tax efficiency difference between mutual funds and ETFs will have no impact for you.

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