World Stock Watch

Unlocking the Tax Benefits of Exchange-Traded Funds (ETFs)

When it comes to reducing tax losses in a portfolio, ETFs have a distinct advantage over mutual funds. According to Bryan Armour, director of passive strategies research at Morningstar, “ETFs come with tax magic that’s unrivaled by mutual funds.” But how does this “magic” work, and which investments benefit the most from it?

Tax Efficiency in ETFs

ETFs are generally more tax-efficient than mutual funds due to their unique structure. Unlike mutual funds, ETF managers can avoid capital gains taxes by using a process called “in-kind redemption.” This means that when an investor sells their ETF shares, the manager can simply hand over the underlying securities instead of selling them and generating capital gains.

Which Investments Benefit the Most?

The tax benefits of ETFs are greatest for investors in taxable brokerage accounts, particularly those who hold U.S. stocks. Over the past five years, about 70% of U.S. stock mutual funds generated capital gains, compared to less than 10% of U.S. stock ETFs. This makes ETFs a more attractive option for investors looking to minimize their tax liability.

Actively Managed Stock Funds: A Good Fit for ETFs

Actively managed stock funds tend to generate more capital gains than passively managed funds, making them a good fit for an ETF structure. However, there are some instances where passively managed funds can also benefit from an ETF structure, such as strategic beta funds.

International-Stock ETFs and Bond ETFs: Special Considerations

While ETFs can offer tax benefits for U.S. stock investors, the same may not be true for international-stock ETFs. Tax laws in various countries can reduce the tax benefits of ETFs, making them less attractive for investors. Bond ETFs also have a smaller advantage over mutual funds, as a larger portion of their returns comes from income rather than capital gains.

Conclusion

ETFs can offer significant tax benefits for investors, particularly those who hold U.S. stocks in taxable brokerage accounts. By understanding how ETFs work and which investments benefit the most from their tax efficiency, investors can make informed decisions about their portfolios and minimize their tax liability.