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Dunned Differently

Adam M. Grossman

EXCHANGE-TRADED funds are popular, but their complex structure makes them difficult to understand. A question I hear frequently: Are exchange-traded funds (ETFs) more tax-efficient than traditional mutual funds?

The evidence suggests they are. One recent study found that ETFs distribute capital gains to shareholders much less frequently than traditional mutual funds and, when they do, those gains are smaller. It’s worth understanding why that’s the case.

Let’s first look at the mechanics of a traditional mutual fund. For simplicity, assume there are just two investors—Smith and Jones—in a hypothetical mutual fund. Also assume that the fund itself owns just one investment: stock in ABC company. The fund purchased these shares several years ago and has a significant unrealized gain on the stock.

Now, suppose Jones wants to redeem his investment in the fund. To meet this request, the fund manager will need cash. Where will it come from? The manager will have to sell some of the fund’s ABC shares. The fund can then send Jones a check to meet his redemption request.

As a result of the ABC sale, the fund will realize a profit. Because mutual funds are collective enterprises, that profit must be shared pro-rata among the fund’s shareholders. That will happen the next time it makes a capital gains distribution.

Unfortunately for Smith, those distributions typically occur only once a year, near the end of the year. By then, Jones will be long gone. Result: Smith alone will bear the tax impact caused by Jones’s earlier decision to redeem his investment. Keep in mind that, while Jones will sidestep the fund’s taxable distribution, he may also face taxes—but his tax bill would result from selling his fund shares for more than he paid.

The above example is greatly simplified. In an actual fund, there would be thousands, if not millions, of shareholders. Because of that, the decision by any one shareholder to redeem his or her investment would likely have scant impact on other shareholders. Still, when it comes to traditional mutual funds, there are no guarantees: You’re always taking a chance tax-wise.

Now, let’s look at how this same situation would work out if Smith and Jones were instead shareholders in an ETF. In this case, if Jones wanted to redeem his investment, he would follow an entirely different process. Rather than asking the mutual fund company to redeem his shares, as in the above example, he would instead sell his ETF shares to someone else.

How would that work? As indicated by their name, exchange-traded funds are bought and sold on stock exchanges. Selling ETF shares looks exactly like selling shares of, say, Microsoft. If you wanted to sell them, you wouldn’t ask Microsoft to redeem them. Instead, you’d simply sell your shares to another investor via a stock exchange.

The way ETF shares are sold makes all the difference. When Jones sells his ETF shares to another investor, it has no impact on the fund itself. Unlike in the above example, the ETF’s manager wouldn’t need to sell anything. That means there would be no tax impact—for Smith, Jones or anyone else—just as there’s no impact on Microsoft when one investor sells his shares to another.

What happens if there’s no one who wants to buy an ETF investor’s shares? There are two answers to that. The first is that, theoretically, an investor like Jones might be stuck. It’s unlikely, but it’s possible. That’s one reason I recommend sticking with the largest and most actively traded ETFs.

The second answer: There is a process for redeeming ETF shares, even when there are no buyers. Institutions that have the status of authorized participants (APs) can turn in a block of ETF shares and receive, in exchange, all of the fund’s underlying holdings. In that way, ETF investors have an escape valve of sorts. Individual investors can’t directly redeem ETF shares like this, but APs are always monitoring exchanges. They’ll start buying up ETF shares when they see that demand from other buyers is weak.

When this process occurs, APs are redeemed “in kind.” They receive the underlying holdings of the fund, not cash. Result: Because none of the fund’s holdings need to be sold, no tax liability is generated. That is what makes ETFs inherently more tax-efficient than traditional funds.

This isn’t to say that ETFs never generate capital gains. Whenever there are changes to a market index, such as the S&P 500, all funds based on that index—including ETFs—must make corresponding changes. That can generate some unavoidable gains, though these changes are infrequent and usually minor.

Also, while they’re a minority in the ETF universe, some ETFs are actively managed. They’ll have a much higher level of portfolio turnover than index-based ETFs and thus generate more gains. That’s why, just as I don’t recommend actively managed mutual funds, I don’t recommend active ETFs.

In these two situations, ETFs may not have an advantage over traditional funds. But they’re also no worse. Overall, because of their exchange-traded structure, ETFs are fundamentally more tax-efficient than traditional mutual funds.

Does this mean you should immediately sell any mutual funds you own and switch to ETFs? Definitely not. Before doing anything, I would weigh three factors.

First, you’ll want to consider whether you have a gain on your mutual fund shares. If so, you wouldn’t want to reflexively sell.

Second, remember that ETFs’ tax advantage only matters in taxable accounts. If you hold a traditional mutual fund—or virtually any other investment—in a tax-deferred account, such as a 401(k) or IRA, you aren’t taxed each year when you receive capital gains distributions.

Finally, it’s worth remembering that mutual funds carry a structural benefit of their own. As I described above, ETFs’ tax advantage derives from the fact that they can be bought and sold on exchanges. It’s a quick and easy process. It’s not, however, guaranteed. It requires that there be a buyer for every seller.

Consider what happened on the afternoon of May 6, 2010. I certainly won’t forget that day. I was at my desk, placing trades, when the broker’s website slowed down. Then, out of the blue, the market went haywire. Among other things, the prices of many individual stocks dropped to just a penny a share. Many ETF prices also fell to irrationally low levels. Within 30 minutes or so, everything was back to normal. But if you had been trying to sell an ETF that day, it would have been a scary episode. By contrast, an investor trying to redeem shares in a traditional mutual fund would have been insulated from the problem altogether.

That episode is now known as the flash crash. A blue-ribbon commission at the SEC later issued a detailed report to help investors understand what had happened. The report deconstructed all the contributing factors. In the end, though, the precise cause doesn’t really matter. The most important thing is simply for investors to understand that something like this can happen.

Similar episodes have occurred since 2010. In August 2015, another flash crash affected the U.S. market. In May of this year, a flash crash hit European stocks. I believe investors should have confidence in ETFs. Still, no investment structure is perfect.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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