Tax efficiency of ETFs

In the next decade, assets under management in ETFs will likely exceed those in mutual funds and reach $35 trillion by 2035¹. Both passive and active ETFs have several well-known benefits—intraday liquidity, low costs and transparency—that are driving this growth and helping ETFs take market share from mutual funds. Yet another feature, tax efficiency, might be one of the most unique but least discussed benefits of the structure. 

Why are ETFs considered tax efficient?

When individuals sell an investment that has gained in value—whether shares of a single stock, a mutual fund or an ETF—they realize a capital gain and, in taxable accounts, will have to pay tax on that capital gain at the end of the year.

So why are ETFs considered tax efficient, especially compared to mutual funds? It has to do with capital gains that are realized when holdings within the mutual fund or ETF are sold, which are then distributed to shareholders at the end of the year and also trigger a capital gains tax liability.

ETFs—both passive and active—consistently distribute significantly fewer capital gains to shareholders than active or passive mutual funds due to fundamental differences in how they are structured and trade. As a result, ETFs are a more tax-efficient investment option than mutual funds for many investors.

The key difference between ETFs and mutual funds—how shares are traded and redeemed—is exactly what creates the potential for ETFs to be more tax efficient on several levels. Even in a down year like 2022, when the S&P 500 returned -18.1%, more than 42% of all active mutual funds distributed capital gains worth a weighted average of 5% of NAV.

Reason #1: Exchange trading

Mutual funds generally transact in cash. When an investor sells shares in a mutual fund, the portfolio manager often sells securities to raise cash to fund the redemption. The act of selling securities leads to some amount of capital gain or loss in the portfolio; at the end of the year, any capital gains are distributed to all shareholders in the fund.

ETFs trade on an exchange, just like individual stocks, allowing an ETF shareholder to redeem shares by simply selling in the open market to a buyer. No positions in the underlying ETF portfolio need to be sold for this transaction to occur, and therefore no capital gain is realized within the ETF that would need to be distributed to the remaining shareholders—a major difference from mutual funds.

Reason #2: In-kind redemption

However, sometimes demand for an ETF is unbalanced, with more sellers than buyers, and market makers step in to absorb the surplus ETF shares. At some point, a market maker may want to reduce its inventory if natural buyers do not exist and has the option to redeem the ETF shares in-kind. In this process, the market maker delivers the ETF shares through an Authorized Participant (AP)² to the ETF issuer in return for the actual underlying positions held within the ETF, which the market maker can then liquidate. For example, when redeeming an S&P 500 ETF, the market maker would receive all the stocks in the S&P 500 in the same weighting as the index and could then sell the individual stocks on the open market.

The in-kind redemption process essentially allows ETF issuers to take ETF shares off the market when there is too much supply. Crucially, that means even in times of net selling, ETFs can avoid the cash transactions that would occur inside a mutual fund and the potential for capital gains that would then have to be distributed to shareholders.

That’s a big and important benefit for the ETF shareholders who are not selling during a time of heavy outflows vs. the potential experience of mutual fund shareholders. In times of market stress, mutual funds that are forced to raise cash to meet net redemptions may trigger meaningful capital gains, which are then distributed to all shareholders—potentially in a year when the value of the fund may have declined.

Reason #3: Cost basis management

In-kind transactions may not only have potential to limit capital gains distributions by minimizing the need to sell securities during redemptions, but they may also offer additional future tax efficiency through the way their tax lots are managed.

Going back to the S&P 500 ETF example, over time, this ETF likely purchased shares of all the stocks in the S&P 500 as it grew, leading to multiple lots of each stock position, each with its own cost basis. When a quantity of S&P 500 ETF shares is being redeemed, the ETF issuer transfers the equivalent quantity of S&P 500 stocks back to the AP. As the issuer takes stocks out of the ETF, the tax lots with the lowest cost basis are sent first (before those with a higher cost basis); this effectively increases the average cost basis for each stock position in the ETF and therefore reduces any unrealized gains and the potential for triggering capital gains.

On the other side of the in-kind transaction, the AP receives shares of each stock at the market closing value on that day. There is no need to carry forward the shares’ original cost basis because they are no longer part of the ETF. Importantly, while in-kind redemptions provide an opportunity for the ETF to increase the average cost basis of its positions and therefore reduce unrealized gains within the ETF, the overall net asset value (NAV) of the ETF remains unchanged—any gains in the ETF shares do not simply disappear. Instead, ETF shareholders will realize the gain (or loss) when they sell their ETF shares and will be taxed at their individual rate.

In contrast, if the underlying shares were sold instead of transferred in-kind, the gain would be realized and distributed (similar to a mutual fund) and the fund’s value would decrease by the proportional amount, much like a dividend distribution. The investor would then be liable for the capital gains tax. Therefore, the in-kind approach empowers investors with more potential for tax management, shifting control from the ETF portfolio manager to the investor.

In some instances, the in-kind redemption process can result in the fund’s portfolio having unrealized losses instead of gains. This tax efficiency is particularly beneficial for active ETFs because it potentially provides portfolio managers with more flexibility to sell positions in the future without triggering taxable events. Additionally, if a loss is realized, it can be carried forward indefinitely to offset future gains. The in-kind redemption process also offers opportunities for tax optimization during portfolio rebalances.

Sometimes capital gains must be distributed

When securities in an ETF are sold at a gain, and not offset by losses before an ETF is required to lock-in its gains, these gains will likely be distributed. The most common reasons are that the ETF had few or no redemptions or that some holdings cannot be redeemed in-kind and therefore must be sold.

The ability to transfer holdings in-kind is primarily driven by geography and asset type. For example, many emerging market countries, such as Brazil, China and India, do not allow locally listed securities to transfer ownership in-kind. Within fixed income, securitized assets, such as agency and non-agency mortgage-backed securities (MBS), asset-backed securities (ABS) and collateralized loan obligations (CLO), are challenging to transfer in-kind.

Spectrum of tax efficiency

ETF tax efficiency has often been associated with passive products, but active ETFs share this benefit, generally making them more tax efficient than both active and passive mutual funds. Passive and active ETFs benefit from exchange trading and the in-kind redemption process. The lower portfolio turnover of passive ETFs makes them the most tax efficient, though active ETFs with lower-turnover strategies are not far behind.

The tremendous growth of ETFs reflects the many benefits investors have found in these vehicles—they are liquid, transparent, easy to trade and have relatively low fees. Increasingly, they even provide access to active strategies that had only been available in mutual funds. The potential tax advantage that both passive and active ETFs have over mutual funds, due to the fundamental differences in each vehicle, is yet another compelling reason for investors to consider an allocation to ETFs.

Learn more about the many roles ETFs can play in a portfolio.

¹Source: Bloomberg, as of August 2024.

²An Authorized Participant (AP) is a self-clearing broker-dealer that contracts with an ETF issuer to facilitate the creation and redemption process.

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