Understanding the Tax Efficiency of ETF’s

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Yesterday one of the things I wrote about was the tax efficiency of ETF’s. Well, I wanted to add a bit more to that today, since I found a compelling little graph that highlights the power behind having tax efficient investments.

The burden of taxes is receiving more attention in recent years, particularly when it comes to the impact of taxes on portfolio performance. This is particularly so, with actively managed funds, where high turnover and potentially greater tax liabilities can really eat into returns. I will talk more to these points during mutual fund week, coming soon. (I wrote a post on the future of US tax rates too)

Tax efficiency is one of the more striking advantages of ETFs, and one of the significant distinctions between mutual funds and ETF’s. In the following graph (the fund data is reported on net transaction costs and management fees), for example, while only 19 percent of active managers in the Small-Cap Blend category underperformed their benchmarks, that number soars to 47 percent when taxes are taken into consideration.

More Control, Fewer Tax Liabilities

Constructed to tightly track an index, ETF’s tend to have lower portfolio turnover and therefore are less likely to realize capital gains, than most active mutual funds. Generally speaking, the only time an ETF makes underlying portfolio changes is when a position is removed from the underlying index and replaced by another one.

Secondly, just like an individual stock, ETFs are bought and sold on the exchange, so your tax liabilities are not impacted by other shareholders’ activities. In contrast, mutual funds do not pay taxes—in the end shareholders do. If a mutual fund realizes capital gains, it is obligated to distribute those gains to every shareholder.

Essentially, shareholders remaining in the fund may receive capital gains for activity they may not have initiated. With ETFs, you avoid potential tax consequences of other shareholder activity; you control your own trading and the resulting tax implications.

In Conclusion

With ETFs, you’re less impacted by taxes and have more room to drive performance. For the most part, passive investing (after taxes) has beaten the performance of active managers in most equity portfolios (for the past 10 years anyway), with the exception of the more aggressive small cap areas.

Much like 2 candidates competing for the same office, there continues to be a raging debate about whether active management is better than passive management and vice versa. Both sides are very vocal and you can find data, all over the internet, that supports the case for both sides.

You know what I think? It’s a secondary concern. I’ll tell you why in my next post…

Tags: ETF, ETF Tax Efficiency, Exchange Traded Funds, Mutual Funds