Finance
Exchange-traded funds have ‘tax magic’ that many mutual funds don’t offer
Israel Sebastian | Moment | Getty Images
Investors who hold exchange-traded funds can often escape a tax bill incurred by those with mutual funds, which are generally less tax efficient, according to investment experts.
ETFs and mutual funds are baskets of stocks, bonds and other financial assets overseen by professional money managers. But they have a different legal structure that bestows ETFs with a “tax magic that’s unrivaled by mutual funds,” Bryan Armour, the director of passive strategies research for North America and editor of the ETFInvestor newsletter at Morningstar, wrote this year.
That tax savings relates to annual capital gains distributions within the funds.
Capital gains taxes are owed on investment profits.
Fund managers can generate such taxes within a fund when they buy and sell securities. The taxes then get passed along to all the fund shareholders, who owe a tax bill even if they reinvest those distributions.
The ETF tax advantage is by virtue of “in-kind creations and redemptions,” which essentially provides for tax-free trades for many ETFs, experts explain. (The ETF’s in-kind transaction mechanism is somewhat complex. At a high level, it involves large institutional investors called “authorized participants,” which create or redeem ETF shares directly with the ETF provider.)
The tax advantage is generally most apparent for stock funds, they said.
For example, more than 60% of stock mutual funds distributed capital gains in 2023, according to Morningstar. That was true for just 4% of ETFs.
Less than 4% of ETFs are expected to distribute capital gains in 2024, Morningstar estimates. Such data isn’t yet available for mutual funds.
Importantly, this tax advantage is only relevant for investors holding funds in taxable accounts, experts said.
It’s a moot point for retirement account investors like those with a 401(k) plan or individual retirement account, which already come with tax benefits, experts said.
The tax advantage “really helps the non-IRA account more than anything,” said Charlie Fitzgerald III, a certified financial planner based in Orlando, Florida, and a founding member of Moisand Fitzgerald Tamayo.
“You’ll have tax efficiency that a standard mutual fund is not going to be able to achieve, hands down,” he said.
However, ETFs don’t always have a tax advantage, experts said.
For example, certain ETF holdings may not be able to benefit from in-kind transactions, Armour said.
Examples include physical commodities, as well as derivatives like swaps, futures contracts, currency forwards and certain options contracts, he said.
Additionally, certain nations like Brazil, China, India, South Korea and Taiwan may treat in-kind redemptions of securities domiciled in those countries as taxable events, he said.
It appears T. Rowe Price is benefitting from the record growth in actively managed exchange traded funds.
Tim Coyne, the firm’s head of ETFs, reports the firm is seeing significant growth in the area — listing the T. Rowe Price Capital Appreciation Equity ETF (TCAF) and T. Rowe Price U.S. Equity Research ETF (TSPA) as two established strategies that can satisfy investor demand.
“I think having that professionally managed portfolio is really beneficial to clients,” Coyne told CNBC’s “ETF Edge” this week. “We’re seeing just… greater volatility [and] uncertainty across both the equity and fixed income markets.“
According to Coyne, the T. Rowe Price Capital Appreciation Equity ETF suits investors who are looking for long-term growth.
“The objective of the fund is to outperform the S&P 500 with lower volatility and greater tax efficiency,” he said. “It’s also a more concentrated portfolio, typically holding around a hundred names.”
As of April 24, the fund’s top holdings include Microsoft, Amazon, and Apple according to the T. Rowe Price website. But it’s not all Big Tech. The ETF also features smaller positions in companies like Becton Dickinson and Roper Technologies.
The T. Rowe Price Capital Appreciation Equity ETF is down about 5% so far this year while the S&P 500 is off about 7% However, the ETF is up close to 8% over the past year — roughly identical to the S&P 500’s performance.
Coyne notes the T. Rowe Price U.S. Equity Research ETF follows a similar strategy, but with a heavier weighting in top tech stocks.
“This is more of a large-cap growth product [T Rowe Price U.S. Equity Research ETF],” he said. “There are components of characteristics of both passive and active here. This fund is actually managed by our North American directors of research. So again, strong fundamental research is going into the stock selection.”
Both the T. Rowe Price U.S. Equity Research ETF and S&P 500 are down around 7% since the beginning of the year. Meanwhile, the fund is up almost 9% over the past year. That’s less than one percent better than the S&P 500’s performance.
T. Rowe Price U.S. Equity Research ETF vs. S&P 500
‘Some form of bear market’
Strategas Securities’ Todd Sohn thinks investment demand for active managers will continue to be strong.
“This is the type of the environment where it [active management] can actually shine,” the firm’s senior ETF and technical strategist said. “We are in some form of bear market. This is where the active manager really can come into hand and offer their solution they are doing right.”
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