The Underlying Mechanics of Why ETFs are More Tax Efficient than Mutual Funds
Timing is everything - in life as well as in the markets.
Exchange Traded Funds (ETFs) have become one of the fastest growing segments of the investment management business for their access, transparency, liquidity, price discovery, fairness, and on average, lower cost.
But what really helped the adoption of ETFs?
Tax efficiency.
The rise of ETFs sprung into life from the widespread adoption of indexing - or the idea that instead of trying to pick geographic regions, sectors, or stocks to beat the index, you just buy funds that hold stocks that represent the index.
This is within the industry coined as passive management.
Since then, it has been shown through numerous research studies demonstrating that active management fails to outperform passive indexing.
Nobel Prize winner William Sharpe’s 1991 The Arithmetic of Active Management in the Financial Analysts Journal stating:
"If 'active' and 'passive' management styles are defined in sensible ways, it must be the case that (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar. These assertions will hold for any time period."
Nobel Prize winner Eugene Fama and Kenneth French also chimed in from their 2010 paper, Luck Versus Skill in the Cross Section of Mutual Fund Returns examine a similar idea:
“The aggregate portfolio of U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations suggest that few funds produce benchmark adjusted expected returns sufficient to cover their costs. If we add back the costs in expense ratios, there is evidence of inferior and superior performance (non-zero true alpha) in the extreme tails of the cross section of mutual fund alpha estimates.”
With passive management on the rise, investors looked for ways to tax effectively track their respective benchmarks.
Enter ETFs.
ETFs have been around since the 1990s but are gaining steam as investors are catching on to what makes ETFs different.
The tax efficiency of ETFs stem from having little, if any, capital gain distributions.
Capital gain distributions represent a fund's net gains, that are distributed to shareholders of the fund.
This is a common attribute of mutual funds.
Where at the end of the year, just like if you bought and sold securities throughout the year, you would report the gain, the same is true for mutual funds.
But ETFs rely on a creation/redemption mechanism that allows for the continuous creation or destruction of ETF shares which reduces, or in many cases, completely eliminating capital gain distributions.
To understand why we wouldn’t want capital gain distributions, consider the following –
In 2021 mutual funds distributed over $822 billion in capital gains to shareholders.
Using J.P. Morgan U.S. Large Cap Core Plus Fund (JLCAX), this fund’s 2022 estimated capital gain distribution is 23.02% of the fund's net asset value (NAV) with $4.15/share in long-term capital gain to be distributed to shareholders on 12/14.
This means if you hold $100,000 in this fund, or 5,186.72 shares, you would receive a 1099 tax form at year end to report a gain of $21,524.88 in long term capital gains, even though you never sold your shares!
If you owned this fund in your taxable brokerage account, owning this fund (on top off it’s grossly overpriced expense ratio of 1.70% with a 5.75% front-load sales charge and 0.25% 12b-1 fee), you would pay an additional $3,228.73 in capital gains tax.
That’s ugly.
This is where ETFs come in to offer relief through their creation/redemption mechanism.
Let’s picture this in action:
When you purchase an ETF, shares of that ETF are transferred in the secondary market from one investor (the seller) to another (the buyer).
ETF shares can only be created by a special group called authorized participants (APs) who submits an order for creation units (usually in batches of 50,000 shares of the ETF) with the company providing the ETF.
These APs are large broker/dealers (Charles Schwab, TD Ameritrade, etc.), often market markers and are authorized by the ETF fund company to participate in the creation/redemption process.
Every day, an ETF manager publishes a list of securities that it wants to own in the fund.
For example, the S&P 500 ETF (VOO) will want to own all securities in the S&P 500 in the exact weight they appear in the index.
The AP creates new shares of the ETF by purchasing these shares in the market in the creation basket based at the right percentages then delivers the shares to the ETF manager for an equal value in shares of the ETF. At which point, the AP can then take those shares and redeem the ETF shares to individual investors.
Because typically the composition of an ETF’s daily creation and redemption baskets mirror one another, APs can quote bid-ask spreads and execute trades throughout the day because the AP knows the composition of the basket that will be needed for delivery or redemption at the end of the day (the ETF company makes this available to APs).
At their core, ETFs are hybrid investment products.
They have features of mutual funds but trade similar to common stocks.
Like mutual funds, investors buy shares in an ETF to own a proportional interest in the pooled assets.
Like common stocks, ETFs are traded continuously on the market (compared to mutual funds which only trade once at the end of the day at the fund’s net asset value).
But unlike stocks, ETFs do not get onto the exchange through an initial public offering, which you may commonly hear referred to as an IPO.
As mentioned above, APs create new shares with the ETF fund company in the primary market to issue amongst buyers and sellers in the secondary marketplace.
This process is vital & helps explain why ETFs have little, if any, capital gain distributions each year.
If you’re an investor with a taxable account, increase your after-tax return by utilizing ETFs in your brokerage account over mutual funds.