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Why Are ETFs (Sometimes) More Tax-Efficient Than Mutual Funds?

A reader writes in, asking:

“Could you provide an explanation of why ETFs are often said to be more tax efficient than mutual funds or index funds? I’ve read about it before but have never been able to follow.”

I’m happy to discuss this, but in order to understand the idea, we have to cover some background information first. Specifically, we have to discuss:

  • One basic concept about the tax treatment of funds, and
  • How shares of an ETF are created.

What Happens When a Fund Sells Something?

Whenever a fund (whether an ETF or traditional mutual fund) sells one of its holdings from the portfolio, if that holding is sold at a gain, shareholders of the fund have to pay tax on their share of that gain (if they hold the fund in a taxable brokerage account, that is).

How ETF Shares Are Created

When an investor buys shares of a traditional mutual fund, the transaction is a transaction between the investor and the mutual fund itself. The investor gives cash to the fund, and the fund creates new shares of the fund, which are given to the investor.

In contrast, when you or I buy shares of an ETF, we’re buying already-existing shares from some other shareholder who already owned those shares. So how do ETF shares get created in the first place?

The answer has to do with entities known as “authorized participants.” Authorized participants are generally super big financial entities (e.g., banks).

When a company that runs an ETF wants to create shares, it essentially does a swap with an authorized participant. It creates new shares of the ETF, and it gives those shares of the ETF to the authorized participant, in exchange for cash or a “basket” of securities (e.g., the 500 stocks in the S&P 500, if it’s an ETF that tracks the S&P 500). These swaps are usually done in very large dollar amounts (e.g., 50,000 shares of the ETF in exchange for the appropriate amount of other securities).

The ETF Tax Advantages

When an investor in a traditional mutual fund wants to sell his/her shares for cash, the transaction is again a transaction with the mutual fund itself. The fund needs to have cash on hand, so that it can pay that cash out to the shareholder redeeming the shares. And sometimes (depending on how many shares are being redeemed on any given day) raising that cash requires selling stuff. And as we discussed earlier, when a fund sells anything at a gain, shareholders in that fund have to pay tax on their share of that gain. In other words, when one shareholder sells his shares of the mutual fund, if the fund has to sell stuff at a gain in order to pay off that shareholder, that creates a tax cost that will be ultimately be paid by the remaining investors in the fund.

In contrast, if you or I want to sell shares of an ETF, that’s a transaction that happens on the secondary market. We aren’t transacting with the fund itself at all. We’re just selling our shares to somebody else who wants to buy them. And that means that the ETF doesn’t have to do anything — doesn’t have to sell anything, and no tax costs are incurred by remaining shareholders in the fund.

In addition, when an authorized participant wants to redeem shares of the ETF, the ETF basically does the share creation process (i.e., the swap described above), just in the opposite direction. This is known as a share redemption. In an ETF redemption, the ETF gives shares of investments to an authorized participant, and the authorized participant gives ETF shares back to the fund. And because this is an “in-kind” transaction, it’s not considered a taxable event. So the ETF is able to hand off those underlying investment shares without technically having sold them — no tax cost.

This is made even more tax-efficient by the fact that, when the ETF swaps out shares of any given company, it will naturally choose to give away the shares that have the lowest cost basis (i.e., keep the ones that have the highest cost basis, in case they have to be sold — thereby allowing any gains that have to be realized to be smaller gains).

So, in short, ETFs are often more tax-efficient than traditional mutual funds because they have a way of satisfying redemptions without having to actually sell anything and because they have a way of strategically unloading their shares of investments with the lowest cost basis (without generating a capital gain in the process).

Two Important Caveats

While the ETF structure does give it some tax advantages over a traditional mutual fund, there are two important caveats to keep in mind.

First caveat: the underlying portfolio and investment strategy of the fund still matters. It matters a lot. For instance:

  1. A fund (whether it’s an ETF or mutual fund) that follows a “total stock market” strategy is going to be much more tax-efficient than an actively managed stock fund that does a lot of buying and selling. Because, as discussed above, selling stuff at a gain results in tax costs to shareholders. So, higher portfolio turnover generally means worse tax-efficiency, and lower portfolio turnover generally means better tax-efficiency — regardless of whether the fund is an ETF or traditional mutual fund.
  2. A fund that pays a lot of fully-taxable ordinary income (e.g., a high-yield corporate bond fund) is simply not going to be very tax-efficient — and that’s true regardless of whether the fund is an ETF or traditional mutual fund.

Second caveat: this whole discussion largely does not apply to Vanguard ETFs as compared to Vanguard index funds. That’s because for many Vanguard funds, the ETF and index fund are literally the same fund. They’re just different share classes. So the share redemption process that ETFs can use (i.e., swapping out shares of holdings with low cost basis, to authorized participants) benefits the Vanguard index funds as well (as long as the index fund in question also has an ETF share class). In addition, the Vanguard patent on this “ETFs as a separate share class of an existing fund” idea recently expired (in May 2023). So it would not be at all surprising if other fund companies eventually implemented the same concept. (And many companies are already actively in the process of doing so.)

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