Remember when Regina George ate Swedish “Kalteen” bars to lose weight in Mean Girls? They had the opposite effect, and she freaked out when she realized what was in them. So mutual funds aren’t exactly like that, but many long-term investors, who can typically enjoy tax-free growth of their assets until they sell, may be surprised by the taxes they owe this year on capital gains distributions, even though they haven’t sold anything.
Tax efficiency is often overlooked when people consider investment choices, and because mutual funds and ETFs are both vehicles to invest in a diverse pool of assets, they are often put in the same basket. However, as the market has risen over the last couple of years and mutual fund owners have continued to have larger tax bills than their exchange traded counterparts, it is important to understand why.
First, while not all mutual funds are actively managed, many of them are. And since the S&P 500 has gained more than 17% this year, active managers will be selling winners to lock in gains and look for cheaper positions. And even though the fund owners didn’t sell anything—they still have their same mutual fund shares—the fund manager did, so the owners have to recognize capital gains distributions on their portion of the fund.
Why don’t ETFs have this same issue? Most are not actively managed, but they are also structured differently. While mutual funds pool investor money and give you representative shares for your portion of the fund, ETFs are created on a unit-by-unit basis—financial institutions buy the basket of stocks represented by an ETF and then sell that unit on the open market. So each investment, while identical, is completely separate.
Second, the gain recognition has been compounded over the last few years as investors have increasingly left actively managed mutual funds for passively managed ETFs. Over the twelve months ending September 30, $240 billion has left actively managed US equity funds. So not only are mutual fund managers are having to selling positions to lock in gains, they are also selling off positions to cash out exiting investors.
So unless you truly believe in the active management style of a particular fund, from a cost and tax efficiency standpoint, ETFs have the upper hand.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.