When touting the benefits of ETFs relative to actively managed mutual funds and even index mutual funds, many investors (myself included) often lead with the lower cost structures and improved flexibility and transparency of ETFs. While the tax efficiency of ETFs relative to mutual funds is often mentioned as a secondary advantage, this benefit is rarely accompanied with a detailed explanation.
Delaying, Not Eliminating
ETFs do not possess some magical repellant to keep Uncle Sam away forever. But because of the way they are created and redeemed (we’ll get to this in a minute), ETFs allow investors to pay accumulated capital gains taxes upon the final sale of the ETF. Conversely, investors in many actively managed mutual funds incur capital gains taxes as the fund managers buy and sell stocks in an attempt (often a futile one) to generate alpha, or when fund managers are forced to sell shares to cash out redeeming investors. So it is important to understand that ETFs don’t eliminate capital gains taxes for their investors, but rather delay the payment of such taxes until the ETF is sold. Nevertheless, since there is a time value of money, delaying capital gains payments can enhance investment returns. The amount of the benefit produced depends on a number of factors, including:
- the investor’s marginal tax rate
- the return generated by the investment
- the investor’s holding period
So How Do They Do It?
The tax efficient characteristics of ETFs result from the way they are created and redeemed. Basically, ETFs are considered to be created by trading equivalent certificates in an in-kind trade. Since the exchange of essentially equivalent securities doesn’t trigger capital gains (as a transaction classified as a sale would), ETF investors are able to delay capital gains as the fund sells shares (for example, in the event of a rebalancing of the underlying index).
ETFs utilize professional market makers who periodically “redeem” shares of the fund. As an example, let’s consider iShares’ Dow Jones U.S. Index Fund (IYY). This fund will hold shares of all the stocks comprising the Dow Jones Index. As these shares rise in value (if we can suspend disbelief momentarily), capital gains accumulate. If the fund sold these shares, a taxable event would occur.
A Regulatory Loophole?
Here’s where the market makers come in. These professionals accumulate a large number of shares of the ETF (typically 50,000) and exchange these shares to the ETF sponsor in exchange for a share in the ETF’s core holdings (in our example, shares of the 30 blue-chip stocks that make up the DJIA). Since this transaction is classified as an “in-kind” redemption (i.e., an exchange of essentially identical assets), the ETF is able to slough off its low basis shares without incurring capital gains at that time. The difference between a trade and a sale may seem minor (some might even call it a regulatory loophole), but the resulting tax impacts are as real as Madoff’s Ponzi scheme.
Exceptions to the Rule
As always, there are exceptions to the rule that ETFs are tax efficient investment vehicles. Inverse and leveraged ETFs, for example, typically hold complex financial instruments in addition to common equities, making “in-kind” redemptions more difficult (check out this article from Matt Hougan at Index Universe for an extreme example). Moreover, ETFs are generally as tax efficient as tax-managed mutual funds, which employ a variety of strategies to minimize investors’ tax liabilities. Regardless, the tax advantages of ETFs generally translate into real dollars in investors’ pockets, a result none of us can argue with.