One of the important aspects of investing is the impact of tax consequences. When investors sell stocks and funds for profit, they are likely aware that these transactions create taxable events. However, they might not be often aware that fund managers also realize capital gains, which are passed on to investors. This means investors are taxed multiple times from the same fund: when they sell it for gains, and when the manager sells stocks within the fund for gains.
This risk for the increased tax burden arises notably from closed-end mutual funds (henceforth referred to as mutual funds), which are portfolios of stocks which could number in thousands. They settle at the end of each trading day, and the fund company is responsible for managing the buying and selling of stocks within the funds.
A good approximation for the level of capital gains passed on to investors from these mutual funds is the turnover rate. This figure shows the volume of transactions that occur within the fund in a year. A turnover rate of 10% means 10% of the total value of the fund is bought and sold in a year. The higher this ratio, the higher the likelihood of investors paying within-fund capital gains taxes.
ETFs, on the other hand, are more tax efficient. This efficiency comes from the fact that ETF companies do not buy and sell stocks themselves, but it is done through large financial institutions such as Bank of America, JP Morgan, and Goldman Sachs that are called authorized participants. Whenever ETF companies make transactions, they engage in in-kind transactions with these authorized participants by transferring stocks to them instead of buying and selling themselves.
Unlike mutual funds that settle once a day, ETFs are traded throughout market hours like individual stocks. At times, they can be traded at a premium or discount of the underlying portfolio values. Since a basket of stocks comprises ETFs just like mutual funds, ETF prices should precisely reflect the value of the stocks inside them. When ETF prices deviate from the values of their underlying stocks, authorized participants buy and sell these ETFs at a premium or discount, while simultaneously trading in the underlying stocks and make profits for themselves. While doing so, they play an important role in equalizing the prices of ETFs to the values of their underlying stocks. Since authorized participants handle the buying and selling, it minimizes the tax consequences for ETF companies and their investors.
While choosing ETFs over similar mutual funds may not result in significant reductions in capital gain taxes, being conscious about tax consequences such as paying attention to the turnover rate and choosing ETFs for taxable brokerage accounts whenever appropriate can make a difference in the long-term performance of your investments.
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The Well Tempered Investor 