How ETFs Manage a Tax-Efficiency Edge over Traditional Mutual Funds By Jim Wiandt September 28, 2001

For all the talk that ETFs are more tax-efficient, there's rarely a detailed explanation of exactly why this is so. As a result, many investors do not truly understand the tax benefits and liabilities of ETFs. It's important to emphasize that ETFs are not a magic potion that will lay Uncle Sam to rest in a field of poppies. There are tax consequences to investing in ETFs, both for the fund and for the individual.

Essentially, for an investor who buys and sells individual ETF shares, the tax consequences are identical to those he would suffer in buying and selling ordinary stock. If you sell less than a year after you buy, the gain in price of the ETF shares will be taxed as ordinary income. When you sell after more than a year, you'll be taxed at a lower capital gains rate (10 percent or 20 percent currently, depending on your tax bracket). If the fund loses value, you can write off the loss against other capital gains (and up to $3000 annually of ordinary income) when you sell.

The simplest way to look at the tax benefits of ETFs is to regard them as a trade. Where ETFs often have nontaxable trades of ETF shares for underlying stock and vice versa, traditional mutual funds generally have sales events, which trigger tax consequences.

Because most ETFs are mutual funds, you are also subject to many of the tax liabilities that apply to mutual funds. That is, when a fund is forced to sell stock to change its composition, for example, when an index rebalances, the fundholders have to pay capital gains on whatever the gain was of the stock that is sold. Here's where it gets tricky, though. ETFs have the potential to make that gain smaller than it might be in a traditional mutual fund. How? Simple. Because ETFs are created and redeemed with stock that is traded in-kind, it is possible to raise the overall cost-basis of the stock that underlies the fund. Whenever a basket of stock is redeemed, the fund gives the redeemer the lowest cost-basis underlying stock. It doesn't matter to the redeemer. He pays based on his individual cost-basis regardless. The net result is that the fund is holding higher cost-basis stock, making the exposure to capital gains less when a particular stock must be sold in rebalancing.

Traditional open-ended mutual funds operate in the opposite manner. When redemptions come in, they sell off their higher cost-basis stock to lower immediate gains, leaving the fund exposed to ever-widening capital gains. This leads us to the other, more widely understood, tax advantage of ETFs. They are not exposed to capital gains that result after redemptions, as traditional mutual funds are. With a traditional mutual fund, when an investor cashes in his or her investment, the fund is often forced to sell underlying stock to pay him or her cash. This results in capital gains to the fund that must be picked up by all shareholders. ETF investors are never subject to this, because nothing in the underlying portfolio changes when an investor buys or sells individual ETF shares. And when an Authorized Participant does redeem ETF shares, it is actually to the collective benefit of the remaining shareholders.

The degree that ETFs hold an advantage over traditional mutual funds depends on two factors. The first of these is the extent to which there are net redemptions on the traditional funds. The more fund shareholders want out of the traditional fund, the more it will cost the remaining shareholders. The second factor is the level of creations and redemptions that occur in the ETF. Of course the more redemptions there are, the more opportunity there is for the fund to slough off its low-cost-basis stock. Let's take a look at a couple of recent scenarios to give you an idea of how murky tax analysis can be.

Brian Mattes, principal at the Vanguard Group notes, "Barclays was making all this noise about how they were more tax efficient than the Vanguard-500 fund, saying that would protect people from taxes. Not only did they not do it (iShares-500 fund made capital gains distributions in 2000) but we did protect people from taxes" (Vanguard paid out zero capital gains distributions on its 500 fund). Mattes feels that if someone is really concerned about taxes, tax-managed funds are the way to go because they have a variety of tax-management tools available to them that the passive ETFs do not. Mattes is also quick to point out that mutual funds are often protected from making significant distributions when shareholders are redeeming shares, because this often occurs when the market is falling and the fund is holding losses to offset gains.

It is difficult, however, to assess the degree of the advantage, since there is little data for most ETFs, since they've been in existence for such a short time. Of the 44-cent-per-share Barclays 500 fund distributed, about 7 cents was in brutal short-term gains. Barclays maintainss that special circumstances and the fund's rapid growth were responsible. Tom Taggart, principal at BGI, says the short-term capital gain for the iShares S&P-500 was due to the new fund experiencing heavy creation/redemption activity as a result of recent significant contributions. In less than a year, BGI's 9.45-basis-point 500 fund went from inception to over $2 billion in assets under management.

In the interest of fairness, it should also be noted that the iShares Russell-2000 fund experienced total distributions of about 43 cents per share (about 0.50% of value) in 2000, while the Vanguard-Small Cap Index Fund was estimated to have total year-end distributions of $2.81 per share (over 13% of value). The reason for this is simple. The Russell-2000 is notorious for high turnover. The new iShares Russell 2000 fund had very little in the way of gains, while the Vanguard fund, which has been around for many years, gets hit hard by all those accumulated gains when it is forced to rebalance.

Unfortunately there is not a lot of historical ETF data to look at, but there does happen to be a very good test case we can examine. One hard cold fact that bears examination is that the granddaddy of ETFs, the SPDRs trust, has paid out one single 9 cent long-term capital gains distribution is its entire 1993-2000 history (and that, it is rumored, owed itself to a mistake in the management of the fund), and no short-term gains. The Vanguard 500, the granddaddy of all index funds, while it didn't pay out any capital gains distributions last year, over the same time period had cap. gains ranging from 21 cents to 55 cents total (topping out at about 0.40% of value). That occurred with no net redemption and a relatively low-turnover index.

One must grant that the Vanguard fund has had more time to accumulate gains...but the preliminaries for the higher-redemption level ETF like SPDRs show a decided tax-efficiency advantage. Ah, if it were only so simple though. Over the 5 year 1995-2000 time period, the Vanguard 500 had a higher total return (not tax-adjusted) than the SPDR - 15.54 to 15.39 percent - owing probably to more creative index fund management. If you had your investment in a taxable account, it appears to practically be a wash. The tax advantage of ETFs over traditional mutual funds, though, especially given significant redemption activity (in either the ETF or in the mutual fund you are comparing it to) and higher turnover indexes is real.