Understanding the Tax Efficiency of ETFs

Having a tax-efficient portfolio is critical for investors. The results of a recent case study by American Century Investments help quantify the tax efficiency of ETFs over mutual funds for both equity and fixed-income vehicles.

Keeping an Eye on Taxes

Advisors and investors tend to look for opportunities to reduce capital gains near year-end. However, thinking about taxes all year long may create better outcomes. Opportunities to offset capital gains with capital losses, known as tax-loss harvesting, can emerge at any time. Take into consideration tax rules that need to be followed when tax-loss harvesting. Other strategies that investors may employ include capital gains avoidance and vehicle selection.

Avoiding Capital Gains

Most mutual fund and ETF providers announce on their websites their estimated annual capital gains distributions beginning in September, with a payable date typically in December. 

Both mutual funds and ETFs are required to distribute capital gains and income to investors at least annually. It’s important to pay attention to these estimates as there can be instances where the capital gains distributed represent a significant amount relative to the asset value. Investors may have an opportunity to sell a fund projecting a significant capital gain prior to the record date, thereby avoiding the taxable distribution. Bear in mind, selling a position may avoid the current year distribution but itself creates a taxable event depending on the price and holding period of the investment.

Taxes on ETFs vs. Mutual Funds

Because of structural differences between mutual funds and ETFs, mutual funds generally incur more capital gains year over year, while the ETF structure minimizes capital gains until shares are sold. Generally, not only are ETFs liquid and low cost, they are also tax efficient. Deferring annual capital gains allows more of the assets to remain invested and potentially compound at a higher rate. As a result, ETFs may be the optimal vehicle for investors keen on managing their annual tax bills. Keep in mind, however, investors are also subject to capital gains tax if they earn a profit from trading their individual ETFs or mutual fund shares (i.e., selling for a higher price than they paid).

Tax Efficiency Across Investment Vehicles

American Century Investments recently analyzed the tax efficiency of various investment vehicles. We found ETFs—both active and passive—were the most tax-efficient vehicles in our study. Figure 1 outlines our findings.

Sources of Tax Efficiency

With mutual funds, flows into and out of the fund are transacted in cash. The manager often must sell portfolio securities to accommodate shareholder redemptions or reallocate assets. These sales may create capital gains for all fund shareholders, not just the ones selling their shares. These gains are taxable for all fund shareholders.

By contrast, ETF managers accommodate investment inflows and outflows through the in-kind share creation and redemption process, which enables them to shed securities that may generate significant capital gains. ETF shares are passed back and forth on the exchange without transactions occurring among the underlying securities. This creates an additional level of liquidity. Trading in kind may help eliminate or significantly reduce costs compared to trading the underlying securities. In addition, when managers rebalance an ETF portfolio, they typically apply tax management strategies, such as tax-loss harvesting, to minimize gains distributions.

Distribution Patterns of ETFs vs. Mutual Funds

We also examined historical capital gains distributions by strategy—index and active—for equity and fixed-income portfolios. Figure 2 shows the percentage of funds distributing in each category from the inception of each fund to December 31, 2022. The percentage of equity ETFs paying capital gains was significantly lower than mutual funds in all categories. It is more challenging for portfolio managers to implements tax-loss harvesting strategies in fixed income ETFs because bonds have specific maturities, durations, seniority, and contractual and temporal risks. However, there were still fewer fixed-income ETFs distributing capital gains. Even for active equity ETFs, only a little over 11% paid out gains, compared with 63% of their mutual fund counterparts. Similarly, 3% of the active fixed-income ETFs paid capital gains, while 13% of active fixed-income mutual funds did.

Using the same categories, we evaluated the average capital gains distribution as a percent of the fund’s net asset value. As Figure 3 highlights, the amount that equity ETFs distribute was significantly lower than mutual fund distributions. In fact, the equity mutual fund distributions were staggeringly larger than the ETF distributions. While not as large a dispersion, the fixed-income mutual funds’ distributions were slightly lower or nonexistent. We attribute the overall lower capital gains distributions to the stock market conditions for 2022.

An Effective Tool for Managing Taxes

Not only do ETFs offer lower cost and liquidity, they also offer tax efficiency, which can aid a portfolio’s overall performance and allow investors to keep more of what they’ve earned invested. Keeping an eye on taxes year-round can help manage the tax bite at year-end.