What makes ETFs tax efficient?

One of the most widely touted benefits of exchange-traded funds (ETFs) is their tax efficiency. But what makes them tax efficient? We discuss the key drivers and how they can work reliably for tax-sensitive investors. 

All else equal, making a choice between investing in an ETF and a mutual fund sometimes comes down to cost—both the cost represented in fund expenses and the cost involved in taxable distributions. In this regard, ETFs are widely recognized as generally being cheaper and far less likely than mutual funds to distribute taxable capital gains.

Over the past five years, on average, less than 6% of equity ETFs paid capital gains to shareholders, while an average of nearly 58% of equity mutual funds paid capital gains. What’s more, at 0.86% of net asset value (NAV), the five-year average capital gain for equity ETFs was roughly 40% lower than the average gain of 1.45% of NAV paid by traditional equity mutual funds.¹

Given the average rarity with which equity ETFs distribute gains, investors might find it surprising that as much as 10% of such ETFs distributed gains in 2017. When we look more closely at the composition of this group, we learn that the more traditional and plain vanilla the ETF’s underlying securities, the lower the likelihood it will pay gains.

In other words, if you own an equity ETF that’s not focused on a relatively illiquid area of the global markets, such as global stocks or emerging markets, or filled with sophisticated security types and leverage, chances are you won’t receive a capital gains distribution at year end.    

Why, then, do equity ETFs seem so reliably able to avoid making distributions? The answer has to do with the way ETFs, unlike mutual funds, are at a structural distance from cash transactions involving investors and the market. 

The average mutual fund is constantly engaged in cash transactions. When investors want to buy shares of an open-end mutual fund, the fund issues new shares as it processes investors’ tendered cash, which typically puts cash to work buying stocks or other securities for the fund’s portfolio. And when investors want to redeem their shares in sufficiently large quantities, the fund must sell securities in order to meet the redemption requests. In other words, investors and traditional mutual funds are locked in a circuit of cash transactions that generates capital gains potential for the fund and all of its investors.

ETFs, by contrast, are insulated from engaging in these types of cash transactions, which is the key to their tax efficiency. Rather than create or redeem shares through cash transactions made directly with fund investors and the underlying markets, ETFs are engaged in a separate circuit of share creation and redemption—a process of in-kind transactions that is nontaxable.    

In the ETF share creation/redemption process, the ETF manager works with authorized participants—which we’ll call brokers—to wrap up (purchase for share creation) or disassemble (sell for share redemption) an underlying basket of the fund’s securities. The process of wrapping up securities and delivering them into the ETF in the form of a creation unit occurs in kind and allows the fund to inject ETF shares of equivalent value into the market. This is done to satisfy rising investor demand.

Alternatively, in the case of declining ETF demand, the fund and the broker work to disassemble creation units, in which ETF shares are returned to the fund by the broker in an in-kind exchange for an equivalent value of securities of the underlying basket. Brokers, in turn, sell that basket of securities to raise the cash necessary to meet end investor redemptions. Neither mechanism of creation or redemption is taxable to the ETF itself—unless, as we’ve suggested, the underlying securities are more illiquid or contract based, which means they have limited or no ability to be transferred in kind. In such cases, the fund would need to sell the security for cash tender, which would generate tax consequences.    

For the investor who buys and sells ETF shares on the secondary market, the potential for capital gains remains. Indeed, whenever you sell a capital asset, whether it’s a house, jewelry, antiques, stocks, or shares of a mutual fund or ETF, if you receive more cash than you paid for the asset, your resulting capital gain may be regarded as taxable income.

But the key difference to understand is that, unlike a mutual fund, the average ETF is not a reservoir of embedded gains potential. While mutual funds are locked in a circuit of buying and selling capital assets with and for cash—and distributing realized gains to shareholders—ETFs operate in a circuit of in-kind transactions, where the “in-kind-ability” of the underlying basket of securities determines whether a gain is even possible to produce.    

To learn more about some of the unique strategies ETFs can help you pursue, explore our page on ETF investing.

1 Morningstar Direct, September 2018.