ETFs are becoming increasingly popular with investors due to their low costs, transparency and ease of investing. However, some investors do not know that ETFs are also very tax efficient specially compared with similar mutual funds.
Since most ETFs track well-known market indexes that rebalance quarterly, they usually experience lower turnover compared with actively managed funds and thus create fewer "taxable events" that result in tax liabilities. For example, the most popular ETF - the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) - has an annual turnover rate of less than 3%.
But more importantly, ETFs are generally more tax efficient due to the way they are structured.
In case of ETFs, we have an authorized participant (AP), also known as a market maker that assembles the appropriate basket of constituent stocks and sends them to a specially designated custodian bank for placing them in a trust. In turn, the custodian forwards the ETF shares on to the authorized participant. This is a so-called "in-kind" trade of equivalent items and thus there are no tax implications.
On the other hand, for mutual funds, creations and redemptions are cash transactions that result in tax liabilities. According to WSJ, a handful of mutual funds planned to make capital gains payouts of nearly 30% or more of their net asset values in December.
However not all ETFs are tax efficient.
Bond ETFs often require frequent rebalancing to maintain their target duration or maturity. Thus, bond ETFs have to pay put capital gains at times but usually the capital gains are minimal. For example, in case of the Vanguard Total Bond Market ETF (NYSEARCA:BND), capital gains were expected to be only 0.05% of its net asset value.
Currency hedged ETFs like the WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ) use derivatives like forward contracts to hedge out the foreign exchange exposure and if the US dollar appreciates significantly during the year, gains from these contracts are required to be distributed to investors.
Precious Metals ETFs like the SPDR Gold Trust ETF (NYSEARCA:GLD) are treated the same as holding the bullion itself. The IRS treats precious metals as "collectible," resulting in high tax rates for long-term capital gains.
MLP ETFs like the ALPS Alerian MLP ETF (NYSEARCA:AMLP), that have more than 25% of their assets invested in MLPs, are treated as C corporations for tax purposes. Further, assets are required to be marked to market and a deferred tax liability for unrealized gains needs to be recorded, returning in large tracking errors.
To learn more, please watch the short video below: