Mutual funds—especially actively managed stock mutual funds—are often tax inefficient. This is because most buy and sell stocks frequently, and they have to pass on any profits from those trades to their shareholders in the form of a capital gains distribution. As a shareholder, you pay taxes on those distributions.
But what about exchange-traded funds (ETFs)? They certainly have a reputation for tax efficiency. And overall, compared to most actively managed mutual funds, stock ETFs do tend to be much more tax-efficient. So why is that the case, and what are the exceptions to this rule?
Most ETFs track indexes
If your fund aims to match the performance of an index, especially a traditional market-capitalization-weighted index (where the biggest companies by market value have the most weight), that fund doesn’t need to do a lot of trading. It’s simply mimicking the holdings of an index, which don’t change frequently. This means fewer opportunities for the ETF to sell a stock for a gain, and by extension, fewer chances that you’ll have to pay taxes on those gains. (Note that index mutual funds tend to be tax-efficient, too, for the same reasons.)
ETFs have a structural advantage
Every time an investor puts money into a mutual fund or takes money out of it, it’s up to the fund manager to accommodate that money. So if a lot of investors want to sell their mutual fund shares, the fund manager will probably have to sell some stocks to raise cash, which can mean capital gains distributions for the shareholders who stay in the fund.
ETF shares, by contrast, usually change hands in the secondary market, from one investor to another. If a lot of ETF shareholders want out of the fund, they simply sell their shares to someone else, and the ETF manager doesn’t have to get involved.
Furthermore, if enough people sell their ETF shares, the price might fall to the point where the ETF is trading more cheaply than the per-share value of the underlying stocks. At this point, a big investor called an authorized participant (AP) will likely buy the less expensive ETF shares and swap them with the ETF manager for the underlying stocks, which the AP can then sell. This is good for ETF investors in two ways:
- This buying up of ETF shares helps push the ETF’s price back toward the per-share value of the stocks in the fund.
- When the ETF manager swaps away the underlying stocks, he or she can give away groups of those stocks that have the biggest baked-in capital gains. That way, if the ETF manager ever does sell those stocks, the capital gains realized will be smaller.
Exceptions to the rule
Now, just because a fund is structured as an ETF doesn’t mean you’ll never pay taxes while you own it. Here are some cases where ETFs aren’t super tax-efficient (though they still have that structural tax advantage compared with mutual funds).
- Bond ETFs: If the ETF owns bonds that pay a lot of interest, it has to distribute that interest to you, and you have to pay taxes on it. Of course, if you’re buying a bond ETF you probably want that interest income. Keep in mind that high-yield-bond ETFs generally distribute more taxable interest than investment-grade-bond ETFs. At the other end of the spectrum, muni bond interest may be tax-free.
- Commodity ETFs: These funds are structured as limited partnerships, and they have to check the value of their portfolio at the end of each year and figure out how much value they’ve gained or lost. The ETF distributes any gains to shareholders, who in turn have to pay the long-term capital gains tax rate on 60% of the gains and the higher short-term capital gains tax rate on 40% of the gains.
- Currency-hedged ETFs: In the past couple of years, as the U.S. dollar rose in value against many foreign currencies, many investors bought ETFs that invested in foreign stocks or bonds but then used various derivatives (futures, swaps and forward contracts) to hedge away the exposure to foreign currency. The ETFs made money from these hedges as the dollar rose in value, and that money was considered a taxable gain to investors.
- High-dividend ETFs: Some ETFs buy stocks that distribute a lot of dividend income. While these dividends tend to be a relatively small portion of the fund’s gain in the long run, they are still taxable distributions (though they’re often taxed at a lower rate than interest income from bonds).
A well-earned reputation
Ultimately, ETFs’ reputation for tax-efficiency is pretty well deserved, especially when you compare typical stock index ETFs to actively managed stock mutual funds. Index tracking and the special structural advantage that ETFs have compared with mutual funds combine to give ETF owners a pretty low tax burden. But if your ETF is getting a lot of money from bond interest, commodities, currency hedging or dividends, you’ll still have to pay taxes even while you hold your ETF shares.
Tax-efficiency is only one consideration when choosing an investment—but it’s an important one, as it’s what you keep that counts.