Question: I am mostly invested in mutual funds, but my friend says I should use exchange-traded funds instead because they have lower taxes. When I ask my financial advisor he says mutual funds work just as well. Who is right and should I be using ETFs instead of mutual funds?
Answer: When it comes to funds, the most important driver of the taxes you pay will be the investment style of the fund’s manager and not the fund’s legal structure. For example, an aggressive manager with a lot of portfolio turnover will generate more tax liability than a passively managed index fund. However, if you have two identical funds — one a mutual fund and the other an ETF — the ETF may be more tax efficient in certain circumstances. But before we get into that, let’s start with some basics.
In the normal course of business, mutual funds and ETFs produce dividend and interest income. In order to avoid paying taxes on that income, the IRS requires funds to distribute all income to shareholders. If they realize capital gains, they must distribute those, too.
The fund manager has some discretion over when distributions occur as long as they are made before year-end. Dividends and interest are earned throughout the year, so most funds make those distributions on a monthly or quarterly basis. Capital gains, however, can change over the course of the year, so most funds distribute capital gains at year-end. Both ETFs and mutual funds report the dividends, interest and capital gains distributions for the year on IRS form 1099-DIV. The tax consequences to investors are identical.
There are some circumstances, however, when ETF investors would be significantly better off. One example is when the fund experiences heavy redemptions. To understand why, I need to explain how mutual funds and ETFs create and redeem shares.
Hold on to your hat. This might get a little technical.
Mutual funds continuously offer shares to the public. This means they can sell as many shares as people want to buy whenever people want to buy them. They can also redeem as many shares as people want to sell. As a result, whenever you buy or sell mutual fund shares, you buy them from or sell them to the mutual fund company.
If a lot of investors want out of a mutual fund, the fund may need to liquidate securities in order to raise enough cash to buy the shares back. These liquidation sales may force the fund manager to recognize capital gains that they would otherwise not take. The result is a double whammy for the remaining investors. First they get hit with unexpected taxable gains. Second, since there are fewer investors in the fund, they get a disproportionate larger share of those gains. Many investors in the 2008 meltdown were surprised by capital gains distributions from their mutual funds, even as the market value of their funds was dropping.
ETFs are different. ETF shares are created when an entity, known as an “Authorized Participant,” or AP, delivers a portfolio of stocks, known as a “creation basket,” to the ETF. The ETF, in exchange, gives the AP a specified number of ETF shares. The AP then sells those shares on the open market and receives cash.
Redemptions are handled in a similar fashion. If a large number of shares are redeemed, the AP presents the shares to the ETF in exchange for the underlying securities. The AP then sells the securities for cash on the open market. There is no forced sale and, therefore, no capital gains are realized or need to be distributed.
APs are generally financial institutions with balance sheets and trading desks large enough to facilitate the massive transactions involved with ETFs. They are also savvy enough to arbitrage any price discrepancies that might arise, ensuring the pricing of a particular ETF stays close the value of the fund’s underlying investments.
Steven C. Merrell is an investment adviser and partner at Monterey Private Wealth Inc., in Monterey. Send questions concerning investing, taxes, retirement or estate planning to Steve Merrell, 2340 Garden Road Suite 202, Monterey 93940 or firstname.lastname@example.org.
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