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Fund watchers during the first several years of exchange-traded funds’ existence took a wait-and-see attitude toward ETFs’ tax advantages. The theory made sense, they said, but let’s see how that theory plays out in the real world. But now analysts increasingly are accepting that ETFs tend to be better at shielding their shareholders from taxes than mutual funds.
Morningstar recently published a study that examined the tax-cost ratios of ETFs that have been around for at least five years, and compared them with the tax ratios of conventional mutual funds. (The tax-cost ratio measures how much taxes would reduce the fund’s return for an investor in the highest tax bracket.) The study found that ETFs tracking small- and mid-cap indices had significantly lower tax-cost ratios than their mutual fund counterparts, particularly among growth-oriented offerings. Mutual funds that invest in smaller growth stocks tend to trade frequently, often triggering significant capital gains.
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Tax-cost ratios on large-cap ETFs were, surprisingly, very slightly higher than those on large- cap funds. The reason: The ETFs’ total expenses were much lower than those of the mutual funds, and those lower expenses meant, ironically, that exchange-traded funds paid out more income and therefore triggered more tax. The extra tax was more than offset by the beneficial effect of lower expenses.
Morningstar analyst Dan Culloton also points out that the vast majority of both domestic and international exchange-traded funds had better than average tax-cost ratios for their categories. He did find a few exceptions, however, including iShares Cohen & Steers Realty Majors and iShares Dow Jones U.S. Real Estate. Those ETFs have not distributed many capital gains, but have paid out a great deal of income—and REIT income, he notes, is taxed as regular income, not at the 15% capital gains rate.
Such high-tax exceptions are few and far between, however. In general, investors holding ETFs in taxable accounts will lose less money to taxes than they would if they invested through conventional mutual funds. At the end of the day, what’s important in investing is how much money you get to keep—and for many investors, ETFs let them keep more.
