As discussed in Tax Efficiency of ETFs, ETFs offer potential tax efficiency advantages. We will examine how this was achieved during market turbulence in 2022. Active ETFs distributed lower capital gains, highlighting the structural benefits of ETFs like in-kind transactions, which helped minimize tax liabilities and enhance potential investor returns.
Exchange-traded funds (ETFs) have revolutionized investment management, offering investors numerous advantages, including liquidity, transparency and, perhaps most significantly, tax efficiency. Data from J.P. Morgan’s Guide to ETFs demonstrates this tax advantage through capital gains distribution patterns across different investment vehicles, with both passive and active ETF structures showing compelling benefits for investors.
Percentage of funds paying capital gains in calendar year
A case study in ETFs’ tax efficiency: 2022’s market turbulence
In 2022, investors contended with high inflation, aggressive interest rate hikes and volatile markets. And mutual fund investors faced an alarming reality: Tax liability occurs regardless of when shares were purchased.
Investors who bought mutual fund shares in October 2022—after markets had already fallen significantly—inherited the same tax burden as longer-term holders. In 2022, large cap active equity mutual funds experienced a vicious redemption cycle with 12.3% average outflows, forcing managers to sell appreciated securities to fund redemptions. This selling generated $31 billion in capital gains distributions, averaging 5.7% of NAV and creating tax liabilities for shareholders who remained invested.1
Active ETFs distributed capital gains averaging just 1.81% of NAV in 2022, substantially lower than the 5.35% distributed by active mutual funds. However, only 8.0% of active ETFs (80 out of 999) paid capital gains, compared to 42.4% of active mutual funds (2,425 out of 5,714).
These results highlight how ETFs’ unique creation/redemption process typically minimizes capital gains distributions regardless of management style. As highlighted in the article Tax efficiency of ETFs, this advantage stems from three key structural features: exchange trading, in-kind redemption mechanisms and cost basis management.
Mutual funds’ hidden tax penalty, and ETFs’ structural tax benefit
The difference in tax outcome between mutual funds and ETFs can be quite stark. When mutual fund shareholders redeem, if there isn’t enough cash in the fund to meet the redemption, fund managers must sell underlying securities, potentially “mutualizing” capital gains distributions to all shareholders in the fund. ETF managers, however, can leverage the creation/redemption process (the ETF superpower) to manage tax consequences while making tactical portfolio adjustments.
The creation/redemption process represents a fundamental innovation in ETFs’ design. Authorized participants (banks) create and redeem ETF shares through in-kind transactions, allowing ETF managers to remove low-cost basis securities without triggering taxable events for shareholders. This structural feature is always advantageous to the investor, but especially during challenging market conditions.
Weighted average capital gains as a percentage of NAV challenge the conventional wisdom that investors must choose between active management and tax efficiency. Passive ETFs remain the most tax efficient at 0.78%, followed by active ETFs at 1.81%, both significantly outperforming passive mutual funds (2.56%) and active mutual funds (5.35%). While investment selection should consider factors such as objectives, time horizon and total costs, the hidden tax penalty associated with mutual funds deserves attention because it can erode long-term returns regardless of market performance.