Back to Basics: Tax Benefits of ETFs

ETFs are almost universally acknowledged to be more tax-efficient than mutual funds. But are ETFs really living up to their reputation?
By Don Dion ,

NEW YORK (TheStreet) -- ETFs are almost universally acknowledged to be more tax-efficient than mutual funds. But are ETFs really living up to their reputation? It's true that most of the time, the basic mechanics of ETFs -- passive management, stock-like trading on the secondary market, and in-kind redemption by Authorized Participants -- give them a tax advantage over their mutual fund cousins. But it turns out that under certain market conditions, index mutual fund managers can harvest losses to create a tax profile that's as low, or even lower, than that of many ETFs. In addition, "enhanced" ETFs, which blur the line between passive and active management, may not offer the same tax advantages of classic ETFs based on broad-market indices.

There are three basic reasons why ETFs beat mutual funds at tax time. The first is passive management. A classic ETF tracks an established index, like the

S&P 500

or the

Dow Jones Industrial Average

, while a mutual fund typically holds an ever-changing portfolio of securities that the fund manager has strategically selected with the goal of outperforming the fund's benchmark. This fundamental difference means that there is far less turnover in an ETF's portfolio. In fact, the only time an ETF would ever need to trade would be when a stock is dropped from the underlying index that it tracks. A mutual fund manager, by contrast, is constantly trading for strategic and tactical reasons.

Assuming the mutual fund manager is talented and is picking stocks that are appreciating, these trades are going to generate capital gains. Mutual fund shareholders must pay taxes on those capital gains each year, net of losses.

The second reason ETFs usually have the tax edge over mutual funds is that ETF shareholders cash out of their positions by trading directly on the secondary market, while mutual fund shareholders must redeem shares through the mutual fund company.

Every mutual fund keeps a certain amount of assets in cash to handle routine redemptions, but when redemption requests outstrip cash reserves, the fund must sell securities. Thus, even though you may be holding your shares, you may still owe capital gains due to excessive redemptions by other shareholders. Again, assuming your fund manager is picking winners, these trades will generate capital gains, and you must pay annual taxes on these gains, net any losses.

The third and final basic reason why ETFs usually present a lower tax profile to the IRS than mutual funds has to do with how Authorized Participants, the institutional investors and market makers that assemble the securities that underlie ETFs, redeem their ETF shares. An institutional investor who wants to market

Blackrock's iShares

, for instance, would acquire large numbers of shares of all the companies in an index, e.g., the S&P 500. Next, the Authorized Participant swaps these shares to Blackrock for shares -- typically 50,000 or more -- of

iShares S&P 500 Index ETF

(IVV) - Get Report

. The Authorized Participant now may market its ETF shares to other institutional and retail customers.

In the event that the Authorized Participant ever needed to redeem shares of its new iShares S&P 500 fund, for instance if it was unable to sell the entire block of ETF shares, the process would work in reverse, i.e., the redemption would be done "in kind." The Authorized Participant would trade its ETF shares back to Blackrock for the underlying securities. Because ETF shares are being swapped for stocks -- and not cash -- the IRS does not consider this a taxable event. Moreover, not only are these redemptions not taxed, but they give the ETF sponsor an opportunity to dispose of the lowest-cost securities that would incur the largest capital gains if they ever had to be sold.

Although ETFs don't generate capital gains in the same way mutual funds do, neither can they capture losses during down markets. Because mutual funds can carry losses forward, severe market corrections can be opportunities for mutual fund managers to eliminate the tax consequences of otherwise taxable events for shareholders several years into the future. Indeed, from March 2000 through March 2003, index mutual funds and ETFs were fairly evenly-matched in terms of tax-efficiency. This was due to index mutual fund managers' ability to harvest losses incurred during the correction and carry them forward into the ensuing bull market years.

ETFs and mutual funds must also distribute dividends and interest income to shareholders. Because ETFs have low expense ratios relative to mutual funds, ETFs tend to pass through larger distributions of income to their shareholders than similar mutual funds.

In addition, with "enhanced" ETFs, investors should be aware that these actively-managed ETFs likely will not offer the tax benefits of classic, passively-managed ETFs based on broad-market indices.

PowerShares Intellidex

funds, for instance, use quantitative analysis to create a periodically-changing index of stocks designed to outperform their peers. The more often an ETF's underlying index changes, the more often the ETF must trade and incur capital gains.

Ultimately, of course, investors must pay capital gains taxes when they sell any non-sheltered investment that has appreciated over time, including ETFs. The best way for individual investors to manage their tax liabilities is to maximize their contributions to employer-sponsored retirement plans -- including the Roth 401(k) -- and take advantage of tax-sheltered savings vehicles such as traditional and Roth IRAs.

Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.

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