Vehicle structure, strategy and asset class impact fund tax efficiency

The bottom line

So, what is the best investment vehicle? Choosing the right investment is like choosing the right car – it can be overwhelming. But investors can follow some simple rules to help increase tax efficiency of their portfolios:

• Investment vehicle structure, asset class & strategy are key drivers of fund tax efficiency.
• ETFs have historically been more tax-efficient than Mutual Funds, regardless of asset class or strategy.
• Placing less tax-efficient investments like Mutual Funds and taxable bonds in tax-advantaged accounts can help guard returns from tax drag.
• With innovation in Active ETFs, investors seeking investment alpha may now also enjoy the greater tax efficiency benefits of the ETF wrapper.

Advisors can use these after-tax investing guidelines to help their clients keep more of what they earn. Earning “tax alpha” for clients also provides an incredible opportunity for advisors to set their practice apart. Keep in mind, advisors should always consider clients' overall portfolio goals and unique tax situations.

What drives fund tax efficiency?

What’s the best car? Well, it depends – do you care more about speed or safety? What terrain will you drive on? What’s your budget? Similar to this question, the answer to “what’s the best investment vehicle?” also depends. Are you looking for low-cost, highly tax-efficient exposure? Outperformance? Something in between?

The answers to both these questions have also evolved with time as new technologies and styles emerged. Flashback to 2000: the number one selling car worldwide was the VW Golf, and there were only a handful of ETFs.^1,2Fast forward to today, the Tesla Model Y leads global car sales, and we now have over 3K ETFs. ^3,4

ETF popularity soared over the last two decades thanks to the innovative benefits they deliver including their low cost, competitive performance, and greater tax efficiency. Whether looking for active or index solutions, the ETF wrapper has historically been more tax-efficient than the Mutual Fund wrapper. ⁵ While we’re still in early days for Active ETFs, so far, they’re showing greater tax efficiency than both Index and Active Mutual Funds.

Percentage (%) of funds that paid cap gains & median cap gain size (%) over the last 5 years

Three drivers of fund tax efficiency: structure, asset class & strategy

What drives the degree of tax efficiency across funds? It typically comes down to three things: 1) vehicle structure, 2) asset class, and 3) strategy.

1) Structure: What car make or model do you want? Differences in ETF and Mutual Fund vehicle structures lead to varying tax outcomes. For Mutual Funds, investors purchase and redeem shares directly with the fund manager. Redemptions from the fund may force managers to sell holdings at a gain, which could cause a taxable event for all investors.

In contrast, investors buy and sell ETFs on an exchange, and the creation and redemption of ETF shares are often done “in-kind” with third party Authorized Participants. The ETF creation and redemption process usually does not trigger a taxable event, allowing holders of ETFs more control over the timing of when they realize capital gains.

ETFs vs. Mutual Funds mechanics

Just as electric vehicles are revolutionizing the car industry, Active ETFs may be disrupting the fund industry by bridging the ETF wrapper’s potential tax advantages with the similar alpha potential of Active Mutual Funds.⁶ Investors are catching onto this attractive combination, leading to 35% annual growth in Active ETFs over the past 3 years.⁷

Since 2021, Active ETFs grew ~35% annually, bringing total AUM to $530bn today (7% of total U.S. ETF market).

2) Asset class: Do you want a sedan, SUV or truck? Regardless of wrapper, investors shouldn’t forget the role that asset class plays in tax efficiency. Asset classes with returns primarily delivered as ordinary income tend to be less tax-efficient than those with returns primarily subject to lower tax rates such as capital gains (if held for more than a year), qualified dividend income, or tax-exempt income.

Tax treatment of distribution from different asset classes

Savvy investors select asset classes based on the overall portfolio objectives while also considering the tax implications of returns. While the tax burden (shown as “Tax Cost” below) isn't significantly different between equity and taxable bond categories, equities have provided higher returns historically, so the Tax Cost has had a greater effect on taxable bond returns.

5-year Tax Cost (%) across asset classes

Regardless of asset class, we still see below that ETFs on average have historically distributed fewer capital gains than Mutual Funds. This holds true for both index and active strategies.

Percentage of funds distributing capital gains by asset class over the last 5 years

3) Strategy: How fast do you want the car to go? Is 0 to 60mph, or 60 to 0mph more important? Velocity of investments can also matter to tax efficiency. Strategies that involve frequent trading to seek alpha may be less tax-efficient compared to strategies that track an index. Looking at Mutual Funds over the past 5 years, we see a positive relationship between higher turnover and larger capital gain distributions.

However, this positive relationship isn't apparent for ETFs over the same period. The ETF structure helps mitigate tax implications for investors as holdings change. This could explain why, compared to Mutual Funds, both Index and Active ETFs have historically distributed fewer capital gains on average.

Vehicle location matters, too.

Where will you park your car? While an all-terrain truck can handle rough weather outside, a protected garage is better for a new sports car. Likewise, sophisticated investors understand the significance of asset location. Investors can manage taxes by parking low-cost Index ETFs in taxable accounts, while parking Active Mutual Funds in tax-advantaged accounts to aim to protect alpha from tax drag. Taking a holistic portfolio approach across accounts can help maximize after-tax returns.

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