Q: Do Exchange Traded Funds (ETFs) have tax advantages over Index Mutual Funds?
A: Exchanged-traded funds (ETFs) are securities that trade on an exchange, hold a basket of various securities, and are priced according to the market. ETFs can hold equities or fixed income securities, and many are designed to mirror an index, such as the S&P 500 or a Lehman Bond Index. The process of buying or selling an ETF is no different than buying or selling a stock.
Index mutual funds are similar to an index ETF. However, index mutual funds are different than ETFs in their construction and how the IRS classifies transactions within each. Because of these differences, ETFs are typically more tax efficient than index funds.
Capital gains or losses are only realized on an ETF when it is sold by the investor; however, a mutual fund will create a capital gains or losses within the fund itself. This will then be distributed to the investors in that mutual fund. Typically there is not a great deal of turnover within an index mutual fund, however it may generate tax liabilities from readjustments needed to fund the redemption of other mutual fund shares (e.g. when another mutual fund holder sell his shares). In addition, investors that sell shares before a mutual fund distributes its capital gains will not only create tax liability, but pass it along to investors who still own the mutual fund.
ETFs do not have this characteristic. To fund a redemption, a mutual fund goes into the open market and sells securities for cash, which is a taxable event. Uniquely, shares are not sold inside an ETF. Rather, the fund exchanges its investments back for its own ETF shares with a third party called an “authorized participant.” The IRS considers these transactions to be “in-kind” and are hence, not taxable. Therefore, no material capital gains are distributed to investors in index ETFs.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. John C. DeMoss, CFA, serves as president of DeMoss Capital. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com.