Most people think exchange traded funds (ETFs) are the same as mutual funds.
Yes and no.
They are both investments that pool together stocks and or bonds in a diversified offering for investors. However, the mechanisms by which they're traded and their tax efficiency make them different animals.
Financial planners should recognize that holding ETFs in non-retirement (taxable) accounts offer measurable advantages.
Mutual funds are priced once a day at the end of the trading session. The mutual fund determines how each underlying holding performed that day and then adjusts the intrinsic value of the fund. This end of day pricing is what mutual fund shareholders receive when they buy or sell.
ETFs trade on an exchange like stocks. The price fluctuates throughout the day and ultimately, price is determined by supply vs. demand. Essentially, what price is a buyer willing to pay for the shares I want to sell? Stock exchanges exist to facilitate these transactions.
This fundamental trading difference matters because mutual fund managers must free up cash by selling underlying holdings to accommodate distribution requests. If there are gains on those underlying holdings when sold, the mutual fund company isn't going to pay those. You do in the form of a "capital gains distribution" wrapped up in the form of a dividend.
Because ETF shares are traded and not redeemed, ETFs don't share this same tax liability.
ACTIVE VS. PASSIVE
Related to the trading difference above is the general philosophy of the mutual fund itself. Most mutual funds are "actively" managed.
We'll save the active vs. passive debate for another post. For this article's purposes, what matters is that most mutual funds attempt to beat the market and their category peers by outguessing everyone else.
This means that they're constantly buying and selling different underlying stocks or bonds depending on which way they think the market winds will blow.
When they sell an investment that has appreciated in value, this triggers a capital gains taxable event. I'll give you one guess who pays those gains.
Correct again. You do as a shareholder!
ETFs are generally structured as Index Funds. By design, the underlying holdings at the beginning of the year are typically the same at the end of the year. Think pure buy and hold.
Since there is little to no internal trading within the index fund, those pesky capital gains never materialize into measurable amounts. This means fewer distributions throughout the year and lower taxable income for ETF shareholders.
QUANTIFYING TAX EFFICIENCY
According to Morningstar, when you analyze mutual funds and ETFs for tax efficiency, you come up with stark differences.
Segregating them by type, asset allocation, and whether they are active (most funds) or passive (index funds), the difference between capital gains distributed as dividends to shareholders produces an ugly tax theme.
The way to interpret this graph is green = good & red = bad. The two far-right columns represent the frequency and magnitude of capital gains distributions.
Actively managed mutual funds score the worst. Effectively, investors that hold actively managed mutual funds in their taxable accounts are being robbed of total return due to the excessive tax drag they're unknowingly incurring.
REAL WORLD CONSEQUENCES
I spent time this spring analyzing Form 1099 based on clients' taxable account activity in 2021. What I found supports the theme Morningstar detailed and discussed in the previous section.
There were a few cases last year where clients transferred in mutual funds held in taxable accounts at competitor firms. These funds had significant embedded capital gains that if sold, would've generated high degrees of capital gains.
To avoid overloading clients with this excessive taxation, I often sell off shares bit by bit each year so the tax bill is spread out. The catch-22 with waiting to restructure the taxable account is that I leave the client exposed to mutual fund capital gains distributions.
Due to the relative unpredictability of mutual fund capital gain distributions, financial planners have an almost impossible task of deciding which tax pain is worse; the pain of selling mutual fund shares with embedded capital gains or holding mutual fund shares in a roll of the dice to hope year-end distributions aren't excessive.
Unfortunately, there is going to be tax pain either way.
ONE CLIENT'S STORY
In one example from last year, we agreed to only replace 1/3 of a taxable account that the client transferred to us. After obtaining the Cost Basis, we knew selling all the mutual funds would've generated a high degree of capital gains.
However, the mutual funds we held onto produced massive year-end capital gains distributions in the form of a dividend. For this $1M taxable account, $50,159 in total dividends (including year-end capital gain distributions like those summarized in the Morningstar paper) were generated.
Only $2,716 of those $50,159 dividends came from the ETFs I implemented for the client. Granted, 1/3 of the total account was converted to the ETFs I recommended, so we have to adjust for that.
However, if 100% of the portfolio would have been invested in my recommended ETFs, we can estimate that only $8,149 in total dividends would have been generated. A far cry from the $50,159 we actually experienced.
Approximately half of the dividends were "nonqualified", which means that ~ $25,000 was taxed at 32% (client's combined state and federal ordinary income rate), and the other half of the dividends were taxed at the 15% cap gains rate.
So, that $50,159 in total dividends added $11,750 to the client's tax bill.
If the client would've owned all ETFs, only $3,829 would've been added to the client's tax bill, representing a tax cost savings of $7,921!
The problem is that in order to position a portfolio for lower dividend distributions, you have to sell mutual funds that often have embedded capital gains. This action creates its own taxable event.
Essentially, in order to set yourself up for lower ongoing taxation (relief) using ETFs, you have to incur temporary tax pain to get yourself there.
The amount of that upfront tax pain and the subsequent break-even point is determined by the amount of embedded capital gains an investor holds with their mutual funds as well as their unique tax circumstances.
There is much nuance and unpredictability with the balancing act of recognizing capital gains when mutual funds are sold against the tax benefits of owning ETFs long term. No one can nail this (not even CPAs) perfectly in any given year. It's a bit of trial and error, but eventually, any investor can divest of their mutual funds over time as ETFs are incorporated as replacements.
Mutual funds aren't bad. They just aren't ideal as investments to be held in taxable accounts.
ETFs aren't perfect either. I'll blog about this more later.
If you want to replace your mutual funds, you need to prepare yourself for current tax pain to achieve less tax pain over time.
This is an extremely headache-inducing project for any investor to tackle. It's best to work with a financial planner familiar with the tax structure of mutual funds versus ETFs.
Aspen Leaf Wealth Management predominately uses ETFs in our portfolio models. This is based on the tax mechanics discussed in this post, the cost of trading, and the "indexing" nature of passive management.
If you'd like us to review your investments, especially those held in your taxable account, just let us know. I'll be happy to review your latest Form 1099 and offer suggestions for improvement.
To initiate a conversation, just click the "Contact" link at the top of this page to reach out and I'll personally answer your message.