ETF tax efficiency in focus amid tax season

There are a lot of things investors like about exchange-traded funds (ETFs), but it looks like ETF tax efficiency may be at the top of the list. And the data on 2020 capital gains distributions shows that ETFs continue to live up to their tax efficient reputation.

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Tax savings drive ETF popularity

2020 was a record-breaking year for U.S. ETFs with net inflows of over $500 billion and nearly 280 new ETFs launched. The size of the U.S. ETF market has grown to over $5 trillion, and the global ETF market is looking to eclipse the $8 trillion mark in short order.¹

One of the main catalysts driving the migration to ETFs is their tax efficiency, according to a recent academic paper.² ETFs are also known for their relatively low fees, transparency, and liquidity, but U.S. investors think tax efficiency is the most attractive feature of ETFs.³

2020 ETF capital gains distributions

The vast majority of ETFs didn't make capital gains distributions in 2020, according to the data available so far.

Only 6% of U.S. ETFs distributed a capital gain to shareholders last year.⁴ This continues the trend of a relatively small percentage of ETFs distributing capital gains in recent years.

Few ETFs paid cap gains distributions in 2020

Morningstar U.S. category
Number of ETFs Number of ETFs paying distributions ETFs paying distributions (%)
  U.S. equity 627   31   5  
  Sector 422   11    3  
  International equity 537   6   1  
  Allocation 66   4   6  
  Taxable bond 381   80   21  
  Muni bond 60   5   8  
  Commodities 54   0   0  
  Alternatives  169   5   3  
  Total 2,316   142   6  
Source: Morningstar, as of 12/31/20.

Why are ETFs tax efficient?

It should be noted that fixed-income ETFs saw the highest percentage of capital gain distributions in 2020. This isn’t surprising given the specifics of how ETF tax efficiency works.

ETFs tend to protect taxable investors from taxes on capital gains, rather than from income. This is important because bond ETFs may produce more consistent income.

I’ve previously written about the creation and redemption process of ETFs that drives some of their attractive features, including tax efficiency. In a nutshell, ETF shares are often created and redeemed “in kind,” and this helps limit cash transactions within the ETF, and limit capital gains distributions.

Softening the bite on tax day

ETF tax efficiency tends to be a popular topic as Americans prepare their taxes before the May 17 deadline. Recent evidence suggests investors like the low costs, flexibility, and transparency of ETFs. They can even be used in tax-loss-harvesting strategies during times of market volatility. However, the inherent tax efficiency of the ETF structure may be the biggest driver of their popularity.

 

1 Cerulli Associates, Morningstar, ETFGI, as of 2/28/21. 2 “ETF Heartbeat Trades, Tax Efficiencies, and Clienteles: The Role of Taxes in the Flow Migration from Active Mutual Funds to ETFs,” Rabih Moussawi, Ke Shen, and Raisa Velthuis, December 8, 2020. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3744519 “US ETF investors mainly motivated by tax loophole, study shows,” Financial Times, 2/14/21. “ETFs Again Proved Their Worth to Taxable Investors in 2020,” Morningstar, 12/15/20.