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Not surprising to any advisor, a key advantage of using ETFs versus mutual funds is the former’s tax efficiency. However, a new Morningstar study explores the sources of ETFs’ tax efficiency verses index mutual funds, and found that  ETFs tend to be more tax-efficient for several reasons, including they distribute fewer (or none) and smaller capital gains, have low turnover and allow deferment of capital gains.

In “Measuring ETFs’ Tax Efficiency Versus Mutual Funds,” Morningstar’s Ben Johnson, director of global ETF research, and Alex Bryan, director of passive strategies, North America, found the two sources key to ETFs’ tax efficiency are their strategy and structure.

As of March 2019, 84% of all ETF assets were invested in funds that tracked market-cap-weighted indexes. These indexes have lower turnover than actively managed as well as non-market-cap-weighted funds, the authors state: “Low turnover tends to reduce realized capital gains and the resulting distributions that managers are required to make.” But this also applies to cap-weighted passive mutual funds.

The study found that over the past three years, the median turnover of a group of market-cap-weighted index ETFs was 17% versus 19% for cap-weighted passive mutual funds. The turnover typically is linked to index changes, thus “less buying results in fewer taxable events,” the authors state.

Although these strategies contribute to the tax efficiency, they are not the primary driver, as many mutual funds offer the same exposure.

Other findings of the Morningstar study included:

  • ETFs’ structure is the primary driver of their tax efficiency. The ability to regularly purge low-cost-basis securities in-kind is a key advantage over traditional open-end mutual funds and has allowed even high-turnover strategies to avoid distributing gains.
  • ETFs usually have a more favorable tax profile than open-end index mutual funds that track the same benchmarks. This is because outflows tend to hurt open-end mutual funds’ tax efficiency, while ETFs tend to be resilient.
  • Though ETFs are more tax-efficient than mutual funds, they are not immune to taxation. Their primary benefit from a tax perspective is that investors are allowed to defer the realization of capital gains taxes.

Structure Is The Key

Structure is the primary source of ETFs’ tax efficiency; the study found, “the differences between how ETF shares and mutual fund shares are created and destroyed have important implications for investors in each wrapper.”

With mutual funds, the buying and selling of shares causes a friction, such as brokerage commissions, bid-ask spreads and market impact. Further, mutual fund managers will hold cash to meet regular redemptions, which can hurt performance in a bull market.

Also, capital gains distributions are “a meaningful part of the cost equation” for mutual funds, because as they have to liquidate securities they are hit with taxable capital gains that are passed on to investors.

The “creation-and-redemption mechanism for ETFs is a completely different animal,” the authors state, noting that most investors deal exclusively in the secondary market. “When supply and demand for ETF shares gets out of whack, actors from the primary market mobilize,” the study states.

From a cost perspective, market makers in the secondary market bear the brunt. Further, as the study notes, “long-term investors do not share in these costs.” There also is less “cash-drag” and “in-kind redemptions allow ETF portfolio managers to purge low-cost-basis positions from their portfolios without unlocking capital gains. This makes ETFs, in general, a far more tax-efficient wrapper than mutual funds.”

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