Tax efficiency has been a key selling point of ETFs, especially for tax-sensitive investors who prefer greater control over the timing and magnitude of capital gains bills.

ETFs’ tax efficiency arises primarily from fewer and smaller capital gains distributions compared to mutual funds.

In a bid to provide greater clarity around this benefit, investment research house Morningstar has released a new report which measures the tax efficiency of ETFs against both actively managed and index mutual funds.

The report, authored by Morningstar’s Director of Global ETF Research, Ben Johnson, and Alex Bryan, Director of Passive Strategies Research, found that ETFs do indeed tend to be more tax-efficient than mutual funds, chiefly because they tend to distribute fewer and smaller capital gains.

Morningstar notes there are two primary sources of this tax efficiency: the first stems from strategy and the second from structure. The former is not necessarily a differentiating feature, but the latter is.

Strategy

The report highlights how the lion’s share of ETF assets is soaked up by funds tracking market-cap-weighted indices. As of March 2019, these funds accounted for 84% of all assets invested in ETFs.

Market-cap-weighted funds tend to have far lower turnover than both actively managed and non-market-cap-weighted index funds. Low turnover tends to reduce realized capital gains and the resulting distributions that managers are required to make. This applies to both ETFs and index-tracking mutual funds.

Structure

While strategy plays a part, Morningstar observes that structure is the primary source of tax efficiency for ETFs.

Specifically, Morningstar refers to the in-kind creation-and-redemption mechanism, conducted by authorized participants, by which ETF shares are brought into and removed from the market.

In-kind redemptions allow ETF portfolio managers to purge low-cost-basis positions from their portfolios without unlocking capital gains. This makes ETFs, in general, a far more tax-efficient wrapper than mutual funds.

To corroborate this statement, Morningstar highlights 56 smart beta ETFs that had an annual turnover greater than 100% over the five years through 2018. Over that span, there were just six capital gains distributions made by three funds in the group.

All three were funds that invest in emerging market stocks, and these funds’ realized gains arose because certain emerging markets stocks cannot be transferred in-kind.

Lastly, the report notes that ETFs tend to have a more favourable tax profile than open-end mutual funds – even on low-turnover index funds – because outflows tend to hurt open-end mutual funds’ tax efficiency, while ETFs tend to be resilient.

Outflows often require mutual fund managers to sell securities, which increases the likelihood that they may realize capital gains that must be distributed. In contrast, ETFs can mitigate the impact of outflows by using the in-kind redemption process to meet withdrawals and remove low-cost-basis shares from the portfolio in a non-taxable transaction.