ETFs vs Mutual Funds: The Secret Sauce to Tax-Efficiency
The ETF structure has a secret sauce called the creation/redemption process that often creates more tax efficiency over the mutual fund.
Exchange-traded funds are investment vehicles similar to mutual funds. But there are key differences between the two types of funds that can affect how much money you make and how you make it. Because of the ETF structure, ETFs generally distribute fewer capital gains to their holders than mutual funds.
3 Ways Potential Tax Benefits of the ETF Accrue to Shareholders
- Open Market Trading to Facilitate Fund Activity
Individuals who want to buy or sell their shares of the ETF may do so by placing an order with their broker. Trades are executed in the open market. Buys and sells are netted against each other, and often, no activity is required within the fund.
- Redemptions Facilitated by the Redemption Process
Mutual funds must meet redemptions by selling securities from within the fund. This selling activity may generate capital gains. ETFs, on the other hand, can often facilitate redemptions by delivering securities through in-kind transfers to the Authorized Participant. No trades are executed within the fund; thus, no capital gains are generated.
- Rebalances May Be Facilitated Through the Creation/Redemption Process
The ETF itself may need to buy and/or sell securities to execute its strategy. Rather than selling shares that must be removed from the fund directly, the ETF sponsor may choose to deliver out securities via a custom basket instead of selling and realizing a capital gain within the fund.
ETFs vs Mutual Funds Tax
If fund shares are appreciating, the holder may eventually need to recognize a capital gain when they choose to sell their shares. This happens when the current market price of the ETF is above the holder’s cost basis. However, the secret sauce to the ETF structure is the ability to defer taxes since the ETF holder can choose when they will eventually realize a potential gain.
Within the mutual fund, the NAV is reduced by the capital gains when they are distributed, effectively distributing the tax burden over the life of the investor’s holding period, rather than the investor realizing at the end in the case of the ETF holder.
In either case, advisers should consider what is in the best interest of their clients whenever deciding between ETFs vs Mutual Funds. If you’re interested in learning more, contact us to discuss how your strategy could benefit by converting to an ETF.
