Exchange-traded funds are a frequent topic of conversation, especially during tax season. Owning ETF shares over other kinds of wrappers can help tax returns look brighter for many investors. As asset managers look to build products that help investors solve problems, understanding ETF tax efficiency is important.

What makes exchange-traded funds tax efficient?

ETFs are positioned to overtake mutual funds as the dominant vehicle. A big contributing factor is that, of all of the ways to assemble a basket of securities, ETFs are among the most tax efficient. There’s a number of reasons why this is the case.

• Low portfolio turnover. In general ETFs, particularly passive ETFs, have low portfolio turnover. This means they are less likely to trigger capital gains distributions when compared to mutual funds. As a result, investors only pay taxes when they sell their own shares for profit. This cost reduction is notable for everyone from traders to operations analysts.
• Primary market transactions. When investors redeem large volumes of ETF shares, the ETF issuer will transfer securities out of the portfolio in-kind rather than selling them directly for cash. In-kind redemptions and creations create less taxable events. These transactions are also where authorized participants might interact with asset manager operations staff, and are relevant to compliance teams. 
• Secondary market transactions. When an ETF is sold on a secondary market, it is sold to another investor and not back to the fund. The underlying securities remain intact, eliminating capital gains triggers. Asset managers who are client facing will find this useful when interacting with investors who are concerned about tax implications. 
• More long-term capital gains. ETF issuers can work with authorized participants to temporarily deposit securities then withdraw appreciated securities to further avoid realizing gains.

Due to the way ETFs are structured and regulated, they have enormous flexibility to manage tax efficiency and allow investors to keep more of their gains.

Related: 7 tips for cost-efficient ETF operations

Tax efficiency of ETFs vs mutual funds

Every investment vehicle faces tax consequences. However, ETF investors are well positioned to mitigate those consequences. Though actively managed ETFs are on the rise, ETFs are traditionally more likely to have passive fund managers when compared to mutual funds, who tend towards having more active managers. But ETFs have additional tax efficiency benefits over mutual funds.

Structural features

The tax efficiency ace in the hole for the ETF structure is the in-kind transaction/in-kind redemption process. This process minimizes capital gains distributions. Mutual fund managers, when they change their positions, create tax events. ETFs potentially avoid tax events by not having to sell the underlying assets. Additionally, ETFs have a lower minimum investment amount.

Exchange trading

ETFs have other structural features that set them apart from mutual funds, notably ETFs can trade throughout the day. Mutual funds are only bought or sold at the end of the day at their net asset value (NAV), whereas ETFs trade throughout the day at or near NAV. 

When mutual funds make a trade, the transaction is typically done with cash. As discussed, this creates taxable events. ETFs can rely on their structural features and trade underlying securities to improve both liquidity and tax efficiency. Because trades are often done in-kind and because of their unique structural mechanisms, ETFs tend to suffer less from cash drag than mutual funds, which will often have to have more cash on hand. More cash on hand means less cash invested into securities, which generally perform better than cash holdings, which can “drag” the performance of a product.

Another factor to be aware of is that ETFs are usually more transparent, disclosing their holdings daily. Mutual funds are typically only disclosing quarterly. This has implications for asset manager compliance teams, but the increased transparency is sometimes helpful for investors.

The role of authorized participants

Authorized participants, which are typically large institutional investors, provide another backstop preventing taxable events for ETF investors. They can manage inflows and outflows, offload gains, and use targeted rebalancing to reduce tax liability and defer gains. 

ETF issuers can offload securities with high unrealized gains to authorized participants through the in-kind redemption process, avoiding capital gains taxes and increasing a portfolio’s average cost basis. Heartbeat trades can also be deployed to enable ETFs to purge low-basis, high-gain stocks minus the typically associated taxable event. Normally, a fund that sells a stock is considered to have “appreciated” and will trigger a capital gains tax. However,a heartbeat trade hands over appreciated stock to an investor instead. This sidesteps the normal tax hit that might come with a redemption. It looks like a “heartbeat” on a chart because a lot of money goes into a fund and then quickly disappears as  the constituent stock is handed over instead of cash.

In fact, because authorized participants are handling more of the redemptions, ETFs very rarely need to sell their underlying securities. As a result, there are fewer taxable events and ETF investors enjoy an unparalleled amount of tax efficiency.

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Strategies for optimizing ETF tax efficiency

ETFs come with a rich slew of tax advantages, and asset managers can lean into that tax efficiency by implementing investment strategies that further minimize capital gains tax, provide their investors with tax advantages, and are clearly documented in the fund’s prospectus. Here’s what to do:

• Avoid forced sales. Take advantage of the in-kind creation and redemption capabilities of the ETF and avoid selling the underlying assets during market downturns. For portfolio managers, this simplifies a part of your job and for traders this helps avoid taxable events and maximize returns.
• Increase cost basis. A higher cross basis means that the net profit is lower. Lower profit means smaller taxable gains.
• Facilitate rebalancing. A rebalancing process naturally involves the selling of securities, but the use of in-kind redemptions allow issuers and authorized participants juggle out low-cost-basis and highly appreciated securities for high-cost-basis securities without generating many (if any) taxable events.
• Use heartbeat trades. Short-term, often large-volume “heartbeat trades” can be deployed to allow an ETF to exchange out embedded capital gains. This provides boosted performance numbers to portfolio managers who can trade off the appreciated securities in lieu of cash and avoid tax hits.
• Focus on low portfolio turnover. Even active ETF managers and portfolio managers should consider when a trade is worth the transaction cost. Keeping your portfolio turnovers as minimal as possible reduces costs and increases tax efficiency.
• Offset capital gains with tax-loss harvesting in taxable accounts. If a security has lost value, that loss can be used to offset capital gains and minimize tax liability. Relationship managers and client portfolio managers will find this useful for high-net worth clients, who typically lean heavily on tax-loss harvesting to protect their earnings.
• Extending holding periods. Capital gains come in two flavors: short-term and long-term. Short-term gains are taxed at a much higher rate, so holding onto securities for longer can boost tax efficiency and reduce tax burden.
• Creating custom baskets. Custom baskets refer to a group of securities that have been placed together. In ETFs, custom baskets can help tax efficiency because it allows for a specific in-kind mix of securities that the ETF issuer wants to redeem. Because the trade is in-kind and the securities aren’t traded for cash, no taxable event occurs. Custom baskets are particularly noteworthy for the flexibility they all product specialists and for quantitative researchers.

These strategies are vital for asset managers who need a powerful way to build and maintain ETF products with after-tax advantages, something that matters for both advisors and end investors.

Potential tax considerations for different asset classes

Different asset classes will have varying amounts of tax efficiency. The quirks and differences between each asset class can be valuable for a host of different financial professionals. Quantitative researchers, risk managers, portfolio managers, and analysts all need to understand the tax efficiency hierarchy. Here’s what they need to know.

• Municipal bonds. Munis are famously tax efficient, as interest is exempt from federal income taxes and sometimes even state or local taxes. Triple-exempt munis exist. This makes them attractive for high-tax-bracket investors.
• Real estate investment trusts (REITS). REITs are extremely tax-efficient as they avoid corporate taxes by distributing at least 90% of their income to shareholders. Investors get a 20% pass-through deduction on ordinary dividends.
• Master Limited Partnerships (MLPs). Much like a REIT, MLPs pass their earnings directly on to shareholders, avoiding double taxation. Distributions are considered return of capital, which is tax-deferred.
• Equities. Equity ETFs enjoy the tax advantages of the ETF wrapper that have been described above. 
• Futures-based commodities. Futures-based commodity ETFs are somewhat tax efficient, thanks to an IRS rule which treats gains as 60% long-term and 40% short-term regardless of holding period. 
• Leveraged products. Leveraged products are meant for trading and not to be held long-term, which makes them less tax efficient than other types of funds.
• Physical commodities. Though a commodity ETF enjoys some of an ETF’s tax advantages, commodities in general often have unfavorable tax rates and a commodities ETF will be less tax efficient than an equities ETF.
• Fixed income/bonds. Because fixed income tends to be taxed as ordinary income, it is less tax efficient than stocks (with the exception of the municipal bond.)
• Trust/currency ETFs. Much like fixed income, currency ETFs are taxed as ordinary income rather than the more favorable long-term capital gains.

Asset managers who understand the tax efficiency of each asset class can make better-informed decisions when building products, as well as set clearer expectations with their investors.

Check out: How market makers support ETF liquidity and pricing

How to talk about tax efficiency benefits with investors and advisors

Relationship managers, client portfolio managers, and salespeople who better understand what their investor and advisor prospects are looking for will have more productive conversations. There are many types of investors and advisors, each with different investment objectives, who are trying to solve different problems. Tax efficiency will be more important to some investors than others. 

It is also worth noting that not all investors understand how to use a product properly. A leveraged/inverse ETF can be deployed by expert traders to make a high-risk/high-reward short term trade. A novice retail investor might not understand that, however, and hold the product for longer than they should.

Working with partners who have an understanding of the financial advisor and retail investor ecosystem can be advantageous to issuers. As you make your innovative product available, you need to understand who your primary investor audience is and how to reach them.

Index partners like VettaFi have active investor-facing media properties that can educate investors on how to best use your products. They also have a robust cache of investor data that can help you get your sales team to get your product in front of the prospects who are most likely to need it. Our index team can help you build a customized investment universe to create a product that is as tax efficient as you need it to be. Talk with our team to learn more.

FAQs: ETF Tax Efficiency

Are ETFs more tax efficient than mutual funds?

Yes, ETFs are generally more tax efficient than mutual funds. The in-kind redemption/creation process that is part of the ETF structure minimizes capital gains distributions, making ETFs significantly more tax efficient than mutual funds.

How are ETF capital gains and dividends taxed?

ETF capital gains and dividends are taxed as follows:

• Capital gains: When investors sell ETF shares for a profit, gains are taxed at either the short-term or long-term capital gains rate depending on the holding period. Long-term rates apply to positions held for more than one year.
• Dividends: Dividends are taxed as either qualified dividends, which are subject to the lower long-term capital gains rate, or as ordinary income, depending on how long the shares were held and the type of dividend distributed.

Are all ETFs tax efficient?

No, not all ETFs are equally tax efficient. While ETFs are generally more tax efficient than mutual funds, tax efficiency varies by asset class, management style, and how the ETF is held. Efficiency matters most when the ETF is held in a taxable account rather than a tax-advantaged account like an IRA.