Market cap weighted index funds tend to be tax efficient. They usually have low turnover because as stocks rise, they naturally become a bigger part of the fund without requiring any trading. In other words, they size themselves. They also usually have steadier flows so that the portfolio manager is less likely to be forced to sell stocks at gains to meet redemption requests. To see how tax efficient index funds can be we can compare the Vanguard 500 Index Fund (VFIAX) to the American Fund Growth Fund of America (AGTHX). All return numbers in this article are ten year returns through the end of February and are estimates from Morningstar. Post tax returns are pre-liquidation, so they reflect taxes on the fund's distributions of dividends and capital gains but not on the sale of fund shares. They also assume an investor at the highest marginal tax rate. Investors in tax sheltered accounts, such IRAs don't have to worry about capital gains taxes. During the past ten years, VFIAX returned 9.72% compared to 9.62% for AGTHX. After tax, VFIAX returned 9.16%, which is a loss due to taxes of about 56 basis points. AGTHX returned 7.85% after tax for a loss due to taxes 177 basis points. VFIAX was much more tax efficient than AGTHX.
But not all index funds are tax efficient. Take the Schwab 1000 Index Fund (SNXFX) for example. The fund is a market cap weighted index of 1,000 large and mid-cap stocks. The fund has suffered from outflows over the years which have hampered the funds ability to be tax efficient. Over the past ten years, the fund has lost about 111 basis points to taxes. That compares to a tax loss of 68 basis points for the Schwab 500 Index (SWPPX). So SWPPX has been much more tax efficient than SNXFX, likely because SWPPX has not suffered the same outflows as SNXFX.
Exchange-traded funds have the potential to be much more tax efficient than mutual funds. When a mutual fund portfolio manager is faced with redemptions, she likely will need to sell stock. If she is selling at a price above the purchase price, she incurs a taxable capital gain. But with an ETF, redemptions are handled with the Authorized Participant and the ETF portfolio manager does not need to sell stock directly to raise cash but rather exchanges shares with the AP. As an example of on ETF, look at the iShares Core S&P 500 ETF (IVV). The fund returned 9.68% during the last decade and 9.22% after tax for a tax loss of 46 basis points. This compares to a tax loss of 94 basis points for the mutual fund Rydex S&P 500 Fund (RYSOX). As another example, the JPMorgan Large Cap Growth Fund (OLGAX) returned 11.66% pre-tax but lost 140 basis points of that to taxes. For comparison, Vanguard Growth ETF gained 10.99% pre-tax but lost only 34 basis points to taxes.
But not all ETFs are tax efficient. The SPDR S&P Dividend ETF (SDY) has a ten year return of 10.52% but only 9.08% after tax for a tax loss of 144 basis points. This compares to a ten year return for the PowerShares FTSE RAFI US 1000 Portfolio (PRF) of 9.82% and an after tax return of 9.09% for a tax loss of 73 basis points. SDY has had 52% average turnover during the past decade compared to just 12% for PRF.
While U.S. equity ETFs tend to be more tax efficient than mutual funds, the ETF structure cannot do much to improve the relative tax inefficiency of bonds. For example, the mutual fund the PIMCO High Yield Fund (PHIYX) had a ten year return of 6.83% and a tax loss of 284 basis points. The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) returned 6.18% pre-tax but only 3.37% post tax for a tax loss of 281 basis points.
In conclusion, market cap weighted US equity index funds tend to be tax efficient but investors should not assume all are. When researching funds that are going to be housed in a taxable account, investors should consider tax efficiency.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VFIAX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.