I keep reading that ETFs are more tax efficient than mutual funds, I don’t understand this. I understand how ETFs (the fund firm itself) does not ever deal in cash whether creating or dissolving ETF shares, all cash transactions are delt with by broker. But I don’t understand how mutual funds which do deal in cash and experience capital gains are taxed inefficiently. From my understanding: Assume a mutual fund holds exactly the S&P index, and issues 1 share to one investor. The mutual fund NAV increases 10%, investor redeems, mutual fund sells all assets and experiences capital gain of 10%. This investment company (“investment company” is the legal entity that holds the NAV of mutual fund as assets on their balance sheet) pays 20% (business tax) on net gains. Delivers 108% of initial S&P index value to investor. Investor experiences 8% gain, pays personal income tax of 20%. Net gain = 6.4%. Assume an ETF holds exactly the S&P index and issues 1 share to one investor (creation process). Investor wants to redeem at the same 10% gain in NAV so he/she sells ETF to broker. Broker gives ETF share to ETF firm (ie. ishares). Ishares dissolves ETF, gives underlying assets to Broker. Broker sells on open market at 110% original value. Broker does not pay taxes (wtf??). Gives the 110% to investor. Investor pays personal income tax of 20%, net gain = 8%. WTF?? is this right??? If so, why the hell is the mutual fund double taxed? So fricking confused. There’s tons of small bits of info talking about ETFs being more tax efficient due to their unique creation and redemption process. I still don’t get it…
This is explained in the CFA curriculum. If you hold a mutual fund and don’t sell your holdings, you will still have to pay taxes because the fund has to sell shares every time a client wants to redeem them.
Ahhh sorry dude, I haven’t started studying for the CFA yet. What level and study session is this in? Can you explain it to me? Correct my understanding: A mutual fund is a jointly owned fund (even though it may be open-ended). If there is a $100 fund, A owns 50%, B owns 50%. Fund grows to $120. B wants to redeem full share, therefore the fund (operating as a legal entity) has to sell 50% of the shares, receiving $60 cash, of which $10 is a cap gain made by the fund. Who gets taxed, when, and where??? Sorry this shit is just not registering for me 4am…
Mutual funds sell stocks whenever they rebalance. So, they incur capital gains taxes even if there are no client redemptions.
Basically when fund manager sells shares in the fund and takes a capital gain. You pay that tax. Of course in an index fund we don’t see that.
Both A and B get taxed on the $10 of capital gain. In this case A has $5 of taxable gain and B has $5. The proportions of the fund’s gain would be different if it weren’t 50/50 ownership of the fund. It obviously sucks for A, who didn’t redeem but has to pay some taxes as if they had. What’s interesting is about B. B redeemed but only got taxed for half of the capital gain that they experienced (assuming that both invested at the same time). So it might seem that the inefficiency on one end (getting cap gains when you don’t sell) gets repaid on the other (not getting fully taxed on gains when you do sell). I think the issue is that the taxes that you pay when you don’t sell are more significant, because they don’t compound. Hence ETFs allow your money to compound better. And you’re not vulnerable to a high tax bill simply because other investors panic. That tax bill will often come during a crisis, which is also when taxes are harder to pay.
It just comes down to turnover in the fund. An actively managed growth fund, for example, may have an annual turnover of 150%. In Dec. you’ll get short and long term capital gains distributions and statement from the fund company that you’ll have to include in your taxes even if you haven’t bought or sold any shares of the fund. Since most ETFs are passive their turnover is much lower, and therefore so are the cap gains distributions. That’s pretty much it.
Okay thanks to everybody who replied. I understand how more cap gain tax can be due from a portfolio that has a high turnover. I also understand how this diminishes the compounding factor because the principle is being reduced (eve though very slightly) by tax bills. I still do not understand how a mutual fund works from a market mechanics perspective. Also my tax law is weak. Please correct my current understanding if applicable: A mutual fund is a singular legal entity. It has “assets” (security holdings). It has no liabilities. If it sells any of its assets at a gain (ie. they must sell because an investor is redeeming), the mutual fund incurs a tax expense which they pay with their cash balance or out of their NAV. If it sells assets which experienced a lost (“depreciation expense”) which is tax deductible from “income”. Tax efficient managers will try to minimize “income” so there is no tax bill incurred. So if capital gains are neutralized, doesn’t this just mean that NAV did not increase at the end of the period? A tax efficient portfolio manager’s job is to make sure NAV does not increase? WTF?? Next scenario: Mutual fund experiences a cap gain tax bill. NAV decreases by the amount of this bill. All investors redeem. When the cash goes into the individual’s bank account, do they have to report income tax again (assuming unregistered account)?? Recommend books on this if possible. I feel retarded.
Capital gains taxes are the responsibility of mutual fund shareholders, not fund management companies. Often, mutual funds make year-end distributions which consist of short-term and long-term capital gains or for the entire year. It gets more complicated than that. Some funds have loss carry-forwards which can be applied against realized gains. However, it all happens at the fund shareholder level, not the management company.
Hi I posted an article on this website http://www.analystforum.com/article/cfa/regarding-the-tax-efficiency-of-etfs-by-joseph-curran
Please check it out, it should clear up some issues you have on the subject…
Joe