S&P's new ETF Research Report provides comparisons for the top 10 mutual funds with the same peer category as the ETF.
ETFs and Tax Efficiency
Unlike actively traded mutual funds, index funds and most conventional ETFs are tax efficient because they sell holdings only when the components of their underlying indexes change. This limited turnover means they realize fewer gains to pass on to their shareholders.
For instance, since 1993 an ETF or index fund that tracks the S&P 500 has sold off shares in an average of 29 companies each year to make way for a comparable number that have been added to the index. This means an annual turnover of less than 6% of their portfolios. In contrast, some actively traded equity funds have turnover rates close to 100%.
ETFs that may not be particularly tax efficient are those that track specialized or nontraditional indexes that regularly update their portfolio components to meet changing market conditions or proprietary criteria. The same is true of enhanced index funds or quantitative funds, which try to do better than their underlying indexes.
Comparing ETFs and Mutual Funds
In general, though, ETFs are more tax
efficient than either active or passive
mutual funds because of the way the two
types of pooled investments are structured.
The first difference is that, with
mutual funds, the actions of other investors
can have a significant impact on your
tax liability. This isn't the case with ETFs.
For example, if your fellow mutual fund shareholders redeem a large number of shares, the fund will probably have to liquidate a portion of its investment portfolio to generate the cash it needs to buy back those shares. At least some of these sales are likely to produce capital gains, and those gains will typically be passed on to you as taxable income.
In contrast, an ETF doesn't redeem shares that shareholders want to sell, so it doesn't have to sell holdings to meet investor demand. This means the ETF has few, if any, capital gains to pass on to shareholders.
The other difference is the impact of the unique creation and redemption process that characterizes ETFs.
Actively managed mutual funds may realize long-term capital gains by selling securities with a low cost basis that have significantly increased in value over an extended period — perhaps to boost the fund's return or because the manager anticipates a falling price. Shareholders owe tax on the gains allocated to their accounts.
If you've been a shareholder for most of the holding period, the tax may be offset by the increased value in your account due to the growth in the security's value. But if you've purchased shares recently, you're being taxed on growth from which you've derived no benefit. Those are known as phantom gains.
In contrast, as ETFs continually exchange the securities in their portfolio for fund shares and create new fund shares in exchange for securities, they regularly return the securities with the lowest cost basis and receive securities with a higher cost basis. As a result, when securities are sold because of changes to the underlying index, there is a smaller profit and more limited capital gains than a mutual fund would produce with the same transaction.
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