ETFs Win Again on Tax Efficiency in 2023

For a moment, forget sheer performance in the exchange traded funds vs. active mutual funds debate. Yes, it’s difficult, but set it aside for a moment. By doing so, the next logical step is to assess which structure is more beneficial to clients.

As has long been documented, the ETF wrapper includes intraday tradability and, broadly speaking, lower fees, which delight clients. Then there’s the issue – a big one at that – of tax efficiency. ETFs have it and most actively managed mutual funds do not. That includes ETFs winning when it comes to capital gains distributions or lack thereof.

ETFs typically feature reduced capital gains distributions. Let’s be honest. If there’s one thing clients hate, it’s getting a year-end tax bill from an underperforming actively managed mutual fund. The point is ETFs, even those that are actively managed, are more tax-efficient than active mutual funds.

Importantly, that trait offered by ETFs has held true across the three-plus the products have been available in the U.S. and it was on display again this year.

ETFs Keep Avoiding Cap Gains

To this point, most of the major ETF sponsors have made 2023 capital declarations and the news is excellent for advisors and clients. The 15 largest issues, which combine for 1,854 ETFs, are projecting that just 1.3% of those funds will lob off capital gains distributions this year. That’s far lower than the already low five-year average.

Of the 10 largest ETFs that are delivering cap gains tabs this year, four are India funds and several others are unique income strategies. This year, sector and thematic ETFs are the offenders in terms of capital gains tabs.

“Half of this year’s heavy distributors are thematic ETFs that belong to the sector equity category group. Indeed, this category group topped the 2023 list for both the number of ETFs distributing capital gains and the number of ETFs distributing more than 1% of their NAV,” notes Morningstar’s Lan Anh Tran. “Much of this can be blamed on the $22.6 billion exodus from sector-equity funds for the year to date compared with the positive inflows that most other broad category groups have enjoyed.”

Of the 1,854 ETFs courtesy of the 15 largest sponsors, 771 are sector funds and international equity products. A combined 15 across those two asset classes are forecasting capital gains distributions. That’s a scant, tolerable percentage.

How ETFs Make Capital Gains Magic Happen

Advisors and some inquisitive clients enjoy knowing what the source of ETFs’ tax efficiency is. It’s explained by the in-kind creation/redemption process with authorized participants.

That process allows for ETF shares to be traded for shares of the underlying securities, thus marking an in-kind transaction and one that isn’t taxable.

“While it’s true that ETFs are generally more tax-efficient than mutual funds, it’s important to remember where these advantages come from,” concludes Tran. “ETFs’ tax benefits aren’t airtight, and taxable investors will still get a bill for regular distributions of income. But most do a very good job of helping investors defer capital gains taxes, allowing them to pay the taxes they owe when they choose and not when others might stick them with the bill, as can be the case for mutual fund investors.”

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