Tax season is a reminder of a lot things. Making sure forms and receipts are in order. Remembering to make last-minute contributions to IRAs for the previous year. Topping off health savings accounts (HSAs) and on and on.
Though less important than those matters, which procrastinators should deal with imminently, tax time also serves as a reminder about the benefits of exchange traded funds (ETFs). Tax advantages are among the biggest reasons why ETFs have pilfered so much market share from actively managed mutual funds over the years.
Much of ETFs’ tax advantage over active mutual funds boils down to the in-kind creation and redemption process used by the former – one unattainable by the latter. There’s more to it, but in simple terms, the in-kind creation and redemption plumbing limits the likelihood of ETFs, even the actively managed funds, delivering capital gains distributions.
Alone, that’s significant because it confirms that it’s not just ETF fees that matter. It’s low total cost of ownership that’s driving so many advisors and professional and retail investors to these funds.
Familiar ETF Themes Loom Large at Tax Time
For investors of all stripes, ETFs’ capital gains advantages, are material, but that situation is amplified for affluent investors. That is to say advisors with high-net-worth clients should extol ETFs’ cap gains virtues over mutual funds.
“History shows that mutual fund distributions are often highest when investors can least afford them. For a client with a $1 million taxable portfolio, a 7% distribution in a down year (like 2022) results in a $70,000 taxable event,” notes Morningstar’s Sheryl Rowling. “At a 23.8% tax rate (including the net investment income tax), that is a $16,660 tax bill on a losing investment. ETFs effectively eliminate this insult-to-injury scenario.”
ETFs are also the superior vehicle for tax-loss harvesting opportunities. In simple terms, tax-loss harvesting is a considerable value add for clients because they likely fall into one of three groups 1) aren't aware of it in the first place 2) know about it and don't know how to implement it or 3) are wanting to hold onto a losing position and don't realize there are benefits to parting ways with that laggard.
“Harvesting losses in a mutual fund can be clunky, often requiring a 30-day wait in cash or temporarily investing in a suboptimal fund to avoid wash-sale rules,” adds Rowling. “The vast universe of specialized ETFs allows advisors to swap between highly correlated but distinct wrappers to maintain market exposure while locking in the tax benefit immediately.”
Solving the Cash Conundrum
Alright, so this isn’t a tax-specific issue, but it’s a fact of life in the ETF vs. mutual fund battle. As advisors know, active mutual funds must hold 3% to 5% of assets in cash to meet daily redemption demand. ETFs don’t have such a mandate and that difference can be significant for clients are investing with multi-year time horizons.
“Because ETFs trade on the secondary market between investors, the fund manager can remain nearly 100% invested. Over a long-term horizon, reclaiming that 3% cash drag can translate to significantly higher compounded growth,” concludes Rowling.
Bottom line: ETFs are modern and they help advisors fulfill their obligation to present clients with the tools needed to minimize tax burdens while potentially boosting long-term upside exposure.
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