Give me a (tax) break: ETFs and tax efficiency

Many investors are going to feel the pain from changes in the tax code on capital gains this year, after a 2013 that left mutual fund investors with unwelcome capital gains payouts to begin with. The best way to end these unpleasant surprises is to avoid unnecessary taxation in the first place.
While exchange-traded funds have long been sold as a more efficient investment vehicle than traditional mutual funds, a major — and potentially misunderstood — facet of that efficiency has to do with taxes. Advisers often ask me what makes ETFs more tax efficient, and while the mechanics of these efficiencies can be onerous, it is worthwhile to break down some key differences of these two popular product categories.
MUTUAL FUND TAXES
Investors in mutual funds have grown accustomed to receiving capital gains payouts each December — a welcome but taxable present just in time for the holidays. By simply holding a mutual fund long term, without even touching the assets, the investor can incur a taxable event. Until the advent of ETFs, this was generally considered a side-effect of investing in diversified funds, but it doesn’t have to be.
Last year, less than 7% of all ETFs paid out a capital gain, versus 65% of the largest 500 mutual funds, and many payouts were quite large. The reason is what puts the “mutual” in mutual fund.
(More: Higher taxes loom for fund investors)
Mutual funds have to pass on a capital gain to shareholders based on sells inside the fund itself throughout the year. While a person who buys and sells stocks all year must ultimately pay taxes, a mutual fund passes on those taxes to shareholders. Often, a mutual fund manager needs to sell positions to fund redemptions by individuals holding the fund. Put simply: Your neighbors have to liquidate their mutual fund holdings to pay for college, and you (who happen to hold the same fund) end up having to pay taxes on their investment decision. How much sense does that make?
ETF TAXATION
Then came the ETF. Through a unique mechanism, ETF managers can move securities (stocks, bonds, etc.) in and out of the fund without necessarily selling them. So when enough investors sell their ETFs, the managers can provide securities in place of cash, and the fund does not incur a taxable event that’s passed to shareholders.
This all can take place through the creation and redemption process, which allows ETF issuers to exchange their underlying securities with specified intermediaries without creating a taxable event for the fund. This mechanism is essentially the cornerstone of ETF efficiency and provides many of the funds’ advantages over traditional mutual funds.
Keep in mind, both mutual funds and ETFs are pass-through vehicles — whatever occurs inside the fund needs to be passed on to shareholders at some point. Dividends and interest flow through the ETF structure just like in a traditional mutual fund, and taxes must be paid on those also, regardless of structure.
Using ETFs as part of an asset allocation can help reduce costs, including the annual payment to Uncle Sam.
Thinking about the proper diversified vehicle to access various asset classes is becoming more critical in an increasingly cost-conscious industry. ETFs are an invaluable tool to avoid unwelcome capital gains distributions and keep a little more money in investors’ pockets.
Grant Engelbart is a portfolio manager at CLS Investments, an Omaha-based investment adviser and ETF strategist for financial advisers and qualified plan sponsors.

Related Topics: Mutual Funds and ETFs, Taxes