ETFs vs Mutual Funds (Part 2 of 3)

by Evan on November 14, 2009

Tax efficiency is a topic that a lot of individuals do not consider when making investment decisions.  In my opinion, this is a huge reason how qualified advisors can help clients.   The concept of tax efficiency is understanding how much taxes will be owed on a particular investment product, and then knowing what to do to minimize this tax.

Mutual funds and ETFs hold many securities and when the fund managers decide to sell the securities in the fund, the fund incurs taxable gains or losses.  These taxable gains or losses are passed along to the shareholders and the shareholders must pay the taxes based on their personal tax brackets.  Of course, if you hold a mutual fund or ETF in a tax deferred account or retirement account then these taxable gains or losses do not affect the client’s tax situation.

Traditional mutual funds are mostly actively managed funds (non-index based funds) and tend to have high turnover rates.  As turnover rates increase, so do the tax consequences of owning the fund.  The turnover rate also affects the cost of the fund, too, since the fund manager is buying or selling securities at a cost (commissions, spreads, and other fees).   Also, it is important to note that no matter if you have held the fund for 1 day or 10 years, if the fund issues a taxable distribution, each client is still responsible for the entire tax consequence!

ETFs are structured in such a way that large money managers are able to “swap” large numbers of shares, most of the time, and not incur a physical sale of the underlying  securities in the fund.   The understanding of this mechanism is beyond the scope of a simple blog, but you can find out more on how ETFs function in this way here:

Needless to say, this leads to lower turnover ratios, and thus lower taxable gains or losses to the holder of the ETF. 

However, do note that this works both ways.  When mutual funds have losses, you can utilize these losses to help offset some taxes.  ETFs will rarely issue a taxable loss, so after prolonged market down moves, some mutual funds may provide tax efficiency by issuing the client losses for usage.   Stay tuned next week for our conclusion to the ETF vs mutual fund blogging!

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