As funds distribute gains in a down market, consider ETFs for tax efficiency

Tax planning is an important component of prudent investing and, as the end of the year approaches, is a topic that’s likely on the minds of investors and financial professionals alike. Generally, investors understand that they’ll need to pay taxes on any realized gains on investments held within taxable accounts.

However, investors could soon be surprised by some mutual funds that distribute capital gains even if the fund has notched losses for the year, leaving investors on the hook for these taxes even if they haven’t sold a single share.

This potential scenario highlights an important advantage of exchange-traded funds (ETFs) over mutual funds when it comes to tax efficiency. Although either investment vehicle can have a place in a portfolio depending on the investor’s specific goals, time horizon, tax situation, or other factors, understanding the differences between ETFs and mutual funds is key, as it can have a considerable impact on a portfolio’s after-tax returns.

2022 mutual fund distributions

As we head into the last few months of the year, mutual funds will begin releasing their 2022 capital gains distribution estimates. These distributions represent the proceeds of the sale of assets by the fund’s manager throughout the course of the year. Investors who hold these funds as of the record date for the distribution are responsible for paying taxes on these gains, regardless of when the fund was purchased.

There are a few important things to keep in mind when it comes to these capital gains distributions. First, mutual fund shareholders can be responsible for paying taxes on these gains even if they occurred before the investor purchased the fund. Second, capital gains distributions can occur even if the fund lost money over the course of the year.

This second point is particularly relevant this year, with many mutual funds experiencing losses as geopolitical tension, soaring inflation, and aggressive central bank action have shaken global markets. The strong stock market over the last several years has also amplified the potential for many mutual funds, particularly those with low turnover strategies, to hold equities with substantial embedded gains.

One trend that’s persisted and makes capital distributions more likely is that mutual funds continue to see net outflows this year. These flows could force portfolio managers to sell appreciated stock positions in order to raise cash to meet these redemptions. This action can trigger capital gains distributions for the remaining shareholders in the fund, even if they haven’t sold their position or made any money on their investment.

This distribution of capital gains in a down market isn’t without historical precedent. For example, during 2018, the S&P 500 Index lost 4.4% on a total return basis. That same year, 73% of equity fund share classes made a capital gains distribution, and 87% of these share classes distributed a capital gain that was over 2% of net asset value (NAV).

ETFs tend to be more tax friendly

Compared with mutual funds, ETFs tend to be more tax efficient due to the unique creation/redemption mechanism that underlies the investment structure. Last year, only 8.9% of ETFs distributed capital gains to investors, and most of those distributions were minimal, representing less than 1% of the average fund’s NAV.

How does the creation/redemption process keep an ETF’s tax burden low?

As mentioned above, net redemptions can sometimes force mutual fund portfolio managers to sell positions in order to raise cash, resulting in a capital gain for the remaining shareholders. However, ETFs are bought and sold on an exchange, relying on authorized participants (APs) to create and redeem large blocks of shares in order to meet demand.

These shares are created or redeemed in kind, allowing for the avoidance of cash transactions and a taxable event. This also means that ETF issuers can reduce any embedded tax liability by transferring out low cost basis shares for those with a higher cost basis, creating the potential for higher after-tax returns. 

ETFs and portfolio repositioning

While the creation and redemption mechanism allows for greater tax efficiency, this doesn’t mean that ETFs are shielded from making any capital gain distributions at all. ETF and mutual fund investors alike should review whether the funds they hold in their portfolios will be making any year-end capital gains distributions.

However, ETFs do tend to be a more tax-friendly structure relative to their mutual fund counterparts. The likelihood and magnitude of any capital gains distributions should be considered in context of multiple factors, including expense ratios, trading costs, and any restrictions such as the wash sale rule. As year end approaches, investors in taxable accounts should consider whether it makes sense to shift their portfolio into more tax-efficient strategies and structures such as ETFs.