ETF and Mutual Fund Taxation: Remind Me Again Why Mutual Funds Exist?

/ETF and Mutual Fund Taxation: Remind Me Again Why Mutual Funds Exist?

ETF and Mutual Fund Taxation: Remind Me Again Why Mutual Funds Exist?

By | 2017-08-18T17:05:27+00:00 January 9th, 2014|Research Insights|14 Comments
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(Last Updated On: August 18, 2017)

Many mutual funds will be sending you a very special gift in the coming weeks — their annual capital gains distributions.

Mutual fund investors get the pleasure of filling government coffers with more of their hard-earned wealth–yippee!

http://www.reuters.com/article/2013/12/11/funds-investors-gains-idUSL1N0JQ1DU20131211

Capital gains pain has arrived for U.S. mutual fund investors, to the tune of up to 60% of net asset value, according to the article.

Meanwhile, back in ETF land, investors are hardly paying any taxes:

iShares Capital Gains - iShares - Google Chrome_2014-01-05_21-12-15

 

Let us all remember that Taxes are More Important than Alpha …you can also review this truism here

So let’s recap ETFs versus Mutual Funds:

  • Lower fees, on average
  • More transparency
  • More investor control
  • WAY better taxes

Why do mutual funds exist again? Oh, I forgot…mutual funds are WAY better for asset managers:

  • Stickier assets
  • Lower transparency
  • Less investor control
  • Cash drag
  • Ability to leverage current distribution channels
  • etc. etc. etc…

The big argument might be that mutual funds possess magical powers to generate alpha. The evidence that mutual funds add value isn’t convincing. However, there is evidence that mutual funds LOVE the broker distribution channel…hawking product…ohhhh….yeaaaaahhh…

Mutual Fund Performance and the Incentive to Generate Alpha

To rationalize the well-known underperformance of the average actively managed mutual fund, we exploit the fact that retail funds in different market segments compete for different types of investors. Within the segment of funds marketed directly to retail investors, we show that flows chase risk-adjusted returns, and that funds respond by investing more in active management. Importantly, within this direct-sold segment, we find no evidence that actively managed funds underperform index funds. In contrast, we show that actively managed funds sold through brokers face a weaker incentive to generate alpha, and significantly underperform index funds.

Any predictions on when ETFs will overtake Mutual Funds? 5 years? 10 years? Never?


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About the Author:

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • Tim

    Hi Wes,

    That’s a very interesting point, but do you think it is a matter of the structure or the management? You can use the tool below to compare the performance — including after-tax on distributions — of Vanguard Funds to their corresponding ETFs. They pairs I checked have very close (give or take a basis point or two) returns, with the fund sometimes outperforming.

    https://personal.vanguard.com/us/faces/JSP/Funds/Compare/CompareEntryContent.jsp?type=fund

    Another small point in favor of funds is that you can buy then at NAV. The spread on some of the smaller ETFs get pretty large.

    Tim

    P.S. Keep up the good work.

  • Yes, the ability to purchase at NAV could be considered a small advantage–great point.

    Also, the relative tax gains of an ETF vs. a mutual fund are marginal when talking about Vanguard buy-and-hold forever funds that generate very little tax liability. However, the Vanguard mutual funds are an exception rather than the rule.

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  • Doug

    What about the actively-managed ETFs, or passive ETFs that have higher turnover? Isn’t the tax issue more a reflection of turnover than structure? (Setting aside the poor schlubs that buy a mutual fund on December 20th and have to pay taxes on 12 months of distributions)

  • Jake

    Your last point is telling. Index mutual funds are the exception. That implies the main difference (and reason the ETFs you outline above do not distribute capital gains) is that index funds don’t distribute capital gains because they rarely sell securities that get the capital gain. So… is this an apples to oranges comparison. The more appropriate question is, do actively managed ETFs distribute capital gains? Do levered ETFs that use derivatives distribute capital gains? The answer in both instances should be yes.

  • There aren’t many active ETFs in the marketplace, so the empirical data lacks depth, but active ETFs can minimize taxes via the create/redeem process. So the comparison is apples to apples.

  • The ETF structure facilitates tax efficiency via the in-kind redemption process. ETF sponsors are able to manage tax basis much more effectively. So even a higher turnover active ETF can distribute minimal capital gains, whereas, a higher turnover mutual fund will stick investors with year-end capital gains.

  • Here is an explanation of the process:
    http://www.invescopowershares.com/pdf/P-TES-WP-1-E.pdf

  • Jake

    Portfolio turnover (actually changing positions) could cause gains in either setting. In the case of mutual fund vs ETF flows in vs out that lead to rebalancing is different. If flows are out, yes an ETF is advantage as there is no need to sell positions. The opposite is the case with flows in. Flows in could actually allow repositioning in a mutual fund with NO taxable event. Example… a portfolio worth $100 that is 100% treasuries wants to be 50% credit. Another $100 flows into the fund. They simply buy credit. In the case of an ETF you need to sell $50 and buy $50, a taxable event.

  • Portfolio turnover can cause gains in either setting, but ETFs have a way to manage basis and minimizing tax liability via the create/redeem process through APs. Mutual funds could theoretically take advantage of in-kind redemption as well, but don’t. What does this mean empirically? Well, a quarterly rebalanced ETF can find ways to distribute ~0 capital gains distributions at year end; mutual funds can’t. That is a MAJOR advantage from the view of a taxable investor.

    I am not tracking on your “flows” concept. For an index ETF, sure, this is possible, but unlikely because of how ETFs manage their tax liability. But in the scenario you mentioned, why would this cause an issue for an active ETF? They can reposition the fund at their discretion