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As advisors well know, exchange traded funds have taken the investing world by storm – a trend continuing in unabated fashion and one showing no sign of relenting.
No longer is it a matter active vs. passive as highlighted by the fact that, led by fixed income funds, actively managed ETFs are rapidly growing. And no, ETF growth isn’t just about lower fees, though that obviously helps. One of the primary drivers of the ETF movement is structure. As in ETFs’ structure makes the products more tax-efficient than actively managed open-end mutual funds.
Tax advantages are among the biggest reasons why ETFs have pilfered so much market share from actively managed mutual funds over the years. Thing is many clients aren’t aware of the tax benefits associated with ETFs and that’s more true for older demographics that widely embraced mutual funds.
In simple terms, odds of an ETF, even many of the actively managed products, distributing capital gains to investors – a taxable event – are long, but the same isn’t true of open-end mutual funds.
Understanding ETFs’ Tax Advantages
The vast majority of ETFs, even the ones that are actively managed, don’t distribute capital gains. In any given year, it’s typical for most ETF issuers to tell advisors and investors that 95% or more of their products didn’t distribute capital gains for that year. Those lofty percentages are annual occurrences, confirming the tax benefits of ETFs.
Intrepid advisors and investors often ponder exactly how ETFs are so much more tax-efficient than mutual funds. Some of the answer is found in Section 852(b)(6) of the U.S. Internal Revenue Code.
“This section allows registered investment companies (RICs) to distribute appreciated property, like securities, to shareholders in redemption of their shares without the RIC recognizing gain,” observes J.P. Morgan Asset Management. “ETFs often utilize Section 852(b)(6) through ‘in-kind’ redemptions involving authorized participants (AP) to manage or defer the taxation of investment gains at both fund and shareholder levels.”
All end users benefit from ETFs’ tax efficiencies, but that’s especially true for institutional market participants and affluent clients. That is to say the “magic” of in-kind redemptions delivers the tax advantages that have made ETFs go-to trading vehicles for a broad swath of market participants.
“The in-kind process typically begins when a market maker needs shares to facilitate purchases from investors,” adds J.P. Morgan. “When this occurs they often collaborate with an AP to create new shares with the fund. This requires the AP to acquire the underlying securities in the ETF and deliver them to the fund in exchange for ETF shares. Conversely, when a market maker accumulates an inventory of ETF shares from investors selling, they can redeem those shares by delivering them to the fund in exchange for the underlying securities, which they then sell in the open market.”
Another Source of ETF Tax Perks
Section 351 of the U.S. Internal Revenue Code features other avenues through which ETF tax superiority shines through. In simple terms, that part of the tax codes allows taxpayers to transfer assets into a corporation without immediate tax obligations. Section 351 is tapped by the seed investors that make it possible for so many new ETFs to come to market.
However, Section 351 isn’t just for fund issuers and providers of seed capital. It’s been around for over 100 years, but it’s increasingly becoming “a thing” in individual portfolios indicating it could be a relevant conversation-starter or value-add for advisors.
“Once within the ETF's structure, assets can be reallocated over time without tax consequences using the in-kind creation and redemption processes,” concludes J.P. Morgan. “It should be noted that the investor’s cost basis for the new ETF will remain the same as the original cost basis and holding period. The investor will eventually pay taxes on gains when the ETF is sold.”