Many people think ETFs (exchange traded funds) are more tax efficient than traditional mutual funds, but is that really the case?
The short answer is “not really.”
That will come as a surprise to many readers, but recent research by Michael Rawson, ETF analyst with Morningstar, shines some light on the subject.
First of all, as a quick refresher course, ETFs and mutual funds are identical in some respects.
Both generate taxable income when they distribute income and dividends to you, the owner.
Both will generate a taxable gain or loss when you eventually sell the funds, assuming you hold the assets in a non-retirement account which is subject to capital gains.
So whether you own an ETF or a traditional mutual fund, you’ll pay tax on income distributions and capital gains. No surprises so far, right?
Surprising conclusion: “ETFs and mutual funds are equally tax efficient”
But what was unexpected was Morningstar’s conclusion that ETFs and mutual funds are equally tax efficient in other respects once you compare apples to apples, meaning once you compare two funds of similar investment orientation.
That means, for example, that an ETF and a mutual fund, both following a low-turnover index strategy focusing on large capitalization U.S. stocks, are equally tax efficient (equally tax efficient means that the IRS takes the same real-life tax bite out of each).
In another example, Morningstar compared two taxable bond index ETFs with two similar bond index mutual funds.
Again, they concluded that the two ETFs “were no more tax-efficient than comparable index mutual funds.”
Reasoned Morningstar, “tax efficiency comes from diligent implementation of a sound low-turnover strategy, not necessarily from some magical tax loophole afforded only to ETFs.”
In plain English, that means your tax bill will be lower if the fund trades less and tends to buy-and-hold. Whether it’s a mutual fund or ETF doesn’t matter.
So why do so many people get the tax story all wrong?
In the mainstream financial media, there is a common misperception that ETFs are more tax efficient than mutual funds, leading to an often unwarranted investor bias in favor of one type of investment over another. So how did this tax story get so garbled?
The truth is that passive (e.g. indexed) investment strategies are more tax-efficient than actively managed strategies (because they trade less). Since most ETFs pursue passive strategies, and most mutual funds pursue actively managed strategies, some people have erroneously concluded that ETFs, in themselves, are more tax efficient. They are not.
What makes an investment tax efficient is not its organizational structure (e.g. ETF vs. mutual fund); it’s more a question of whether it pursues a passive or active investment strategy.
Now that we’ve got that straight…..
Here’s the final takeaway. It’s good to see the trees, but it’s more important to understand the forest.
Some financial commentators just can’t see past the trees. Tax efficiency is an important factor. But it’s not the only factor, by any means.
We’ll let Morningstar have the last word here (well, almost).
“It is important to remember that it is the total after tax return that is most important, not necessarily minimizing taxes.”
That means that you should look at performance like we do. The best performer is not the one that is most tax efficient, but the one that leaves you with the most money after fees and taxes are taken into account.