Study: ETFs Come Out Ahead in Tax Efficiency

by on May 27, 2009 | ETFs Mentioned:

By now, many investors have heard countless times the advantages of ETFs over mutual funds: lower costs, tax efficiency, improved transparency, etc., etc. While the cost issue is relatively straight forward, the tax advantages of ETFs are a bit more confusing. Even with a detailed explanation, this advantage remains a largely theoretical concept for most investors. But the results of a new study completed by Morningstar allow us to quantify the tax advantages of ETFs.

What’s the Big Deal?

ETFs are designed to provide relatively low capital gains distributions to investors. This is important for several reasons. First, capital gains distributions often force investors to sell some holdings to cover the required taxes. Second, for investors in high income brackets, capital gains may be taxed at higher rates than if they had been delayed until retirement.

Numbers Don’t Lie

Scott Burns, Director of ETF Analysis at Morningstar, compiled the capital gains distributions for equity-based ETFs across 27 broad-based indices over five-year, 10-year, and 15-year time horizons. The results were then compared to capital gains distributions for open-end mutual funds that tracked similar benchmarks. As expected, ETFs clearly demonstrated superior tax efficient attributes relative to open end mutual funds. Only two ETFs (ONEQ and FEU) made capital gains distributions over the five-year period, and only one (MDY) did so over the 10-year period.

The results were drastically different for the open end mutual funds. Of the 27 groups, 25 made capital gains distributions over the last five years, with several in small-cap categories making distributions larger than 5% of total asset value. While these differences may not result in such obvious savings as lower expense ratios, the effect on your portfolio, especially over the long-term, can be material.