Adding alpha in taxable portfolios with active ETFs

Key takeaways:

• The greater tax efficiency of ETFs can potentially make it easier for actively managed ETFs to outperform their market benchmarks after taxes.
• Higher potential after-tax returns can suggest a higher allocation to active strategies in taxable accounts.
• When deciding whether to choose an active or indexed strategy, consider market efficiency, manager skill, and your own track record of picking and holding onto managers.

For a long time, the rule of thumb for many tax-sensitive investors has been to hold indexed ETF strategies in taxable accounts, and active mutual fund strategies in qualified accounts.

After all, the difference in tax efficiency between active mutual funds and index ETFs has been huge: over the last 5 years, 53% of active equity mutual funds paid out a capital gain in an average year, compared to just 4% of index equity ETFs.

Yet active ETFs can serve as a bridge between these two worlds: offering the nimbleness of an active manager with the potential for greater tax efficiency of the ETF structure. Just 16% of active ETFs have distributed capital gains over the last five years.

Vehicle matters: ETFs have historically been more tax efficient than traditional mutual funds
Percentage of funds that distributed capital gains & median capital gain size over the last 5 years

Capital gains distributions directly translate into current-year taxes, since those paying the highest marginal tax rate have to pay a 40.8% federal tax on short-term gains and a 23.8% tax on long-term gains. Capital gain distributions have contributed to a 2% annual tax cost, from the average large cap mutual fund, quite a big hurdle for active managers trying to beat a benchmark after taxes and fees.¹ While paying taxes at some point may be inevitable for investments that appreciate in value, the ability to defer the realization of those gains – rather than realize them right away due to fund distributions – can be valuable in driving higher compounded returns over time.

Active ETFs: a more efficient vehicle for delivering potential alpha to taxable portfolios.

Taxes can make a big difference. Consider that the average top quartile large cap fund has beaten the S&P 500 index by 0.82% per year over the last 5 years… but underperformed by 1.46% after taxes.

Top quartile funds have beat the S&P 500, but underperformed on an after-tax basis
5Y pre- and post-tax returns for top quartile large cap funds, as of 7/31/24

One example of a newer ETF that has done well is the BlackRock Large Cap Value ETF (BLCV). Launched in May 2023, it recently hit its 1-year birthday, and has been able to deliver strong returns… both before and after taxes.

The BlackRock Large Cap Value ETF has delivered competitive pre- and post-tax performance
1Y pre- and post-tax returns

How do actively managed ETFs work?

ETFs may deliver a more tax-efficient experience than mutual funds due to differences in how shares are created and – more importantly – redeemed. When an investor wants to redeem shares of a mutual fund, the fund company sells securities to raise cash, and realized net gains are passed on to remaining fund investors as taxable distributions.

In contrast, many ETFs can be redeemed in-kind, through authorized participants (APs). This means that, instead of the fund provider having to sell securities to raise cash, it can exchange shares of the ETF for shares of the underlying securities. Critically, these in-kind transfers between APs and ETF issuers are not taxable events for ETF investors.

While ETFs tend to be a more tax-efficient wrapper than mutual funds, the underlying assets and strategy matter too. Fixed income, as an example, tends to generate a lot of its returns from generating income that is distributed each year and taxed at ordinary income rates regardless of holding period. Holding bonds in an ETF wrapper doesn’t make them much more tax-efficient. Active equities is one area in particular where the ETF wrapper can make a difference, since reducing capital gains distributions can have a large impact on the strategy’s ability to compound returns over time.

Building active ETFs into your portfolio construction process

Tax efficiency is just one element in determining where to look for alpha with active ETFs. Consider three big questions first:

• Are there opportunities to generate alpha within the manager’s target market?
• Does the manager have a track record of delivering alpha in that space?
• Do you, the investor, have a track record of picking and holding onto good manager?

The process for picking an active ETF looks a lot like the process for picking any active manager: it starts with evaluating the manager, making sure you’re comfortable with the fund’s exposure, and that the risk profile, total cost (including taxes) and realized performance are all reasonable.

Active ETFs to consider

A few equity strategies to consider include the BlackRock Large Value ETF (BLCV) mentioned above, the BlackRock U.S. Equity Factor Rotation ETF (DYNF), and the BlackRock Long-Term U.S. Equity ETF (BELT). Past performance is no guarantee of future results. For standardized returns, please click on each ticker.

• The BlackRock Large Cap Value ETF (BLCV) aims to outperform the Russell 1000 Value Index by avoiding “cheap for a reason” stocks and seeking out attractively valued companies with price appreciation potential. It has beaten its benchmark index by nearly 6 percentage points over the past year.²
• The BlackRock U.S. Equity Factor Rotation ETF (DYNF) actively rotates between exposure to the quality, momentum, value, size and low volatility factors, and also actively selects stocks that are attractive based on those characteristics. Like BLCV, DYNF has thus far delivered attractive returns: it has returned 11.71% annually over the last 3 years, and 10.94% annually after taxes – above the iShares Core S&P 500 ETF (IVV), which has delivered 9.98% annually pre-tax and 9.58% annually post-tax over that same time period.³

• The BlackRock Long-Term U.S. Equity ETF (BELT) is a concentrated portfolio of high conviction names. While the ETF recently launched in June 2024, limiting its track record, we do see a lot of potential for long term growth in high active share strategies that make big bets away from benchmark.

Ultimately, portfolio builders should consider alpha-generating opportunities where they can find them, while optimizing their portfolios for an appropriate level of tracking error: after all, strategies with the potential to outperform also have the potential to underperform. The good news with active ETFs is that their typically lower tax costs ease the hurdle for potential outperformance.

BlackRock can help you figure out how to build active ETFs into your portfolio construction process. Contact your BlackRock representative for more information or explore our online investment tools and resources.

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