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The Tax Efficiency of ETFs

While mutual funds tend to incur more capital gains year over year, ETFs minimize capital gains until shares are sold. Not only are ETFs liquid and low cost, but they’re also tax efficient.

A blog post from American Century Investments notes that deferring annual capital gains allows more assets to remain invested and possibly compound at a higher rate. ETFs may be ideal for investors looking to manage their annual tax bills.

With mutual funds, flows into and out of the fund are transacted in cash. The manager often must sell portfolio securities to accommodate shareholder redemptions or reallocate assets. These sales may create capital gains for all fund shareholders, which are taxable.

By contrast, ETF managers accommodate investment flows through the in-kind share creation and redemption process, which allows them to get rid of securities that may generate capital gains. ETF shares are traded without transactions occurring among the underlying securities, which creates additional liquidity. Trading in-kind may help eliminate or reduce costs compared to trading the underlying securities.

After examining historical capital gains distributions by strategy — index and active — for equity and fixed-income portfolios, American Century found that the percentage of equity ETFs paying capital gains was substantially lower than mutual funds in all categories. Fixed-income ETFs can’t always transfer certain securities in-kind, so creating custom baskets is much more challenging.

Because bonds mature regularly, portfolio managers can’t take advantage of the same tax-loss harvesting strategies as they can for stocks because they need to manage to specific durations. However, there were still fewer fixed-income ETFs distributing capital gains. Even for active equity ETFs, less than a quarter (20%) paid out gains, compared with 82% of their mutual fund counterparts.

Using the same categories, American Century assessed the average capital gains distribution as a percent of the fund’s net asset value. The amount that equity ETFs distribute was far lower than mutual fund distributions. In fact, the equity mutual fund distributions were twice as big as the ETF distributions.

“Not only do ETFs offer lower cost and liquidity, they also offer tax efficiency, which can aid a portfolio’s overall performance and allow investors to keep more of what they’ve earned invested,” American Century argues. “Keeping an eye on taxes year-round can help manage the tax bite at year-end.”

For more news, information, and strategy, visit the Core Strategies Channel.

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