Q&A with IFA: ETFs vs. Tax-Managed Funds

Q&A with IFA: ETFs vs. Tax-Managed Funds

Q&A with IFA: ETFs vs. Tax-Managed Funds

Question: I have heard that exchange-traded funds (ETFs) are more tax-efficient (have lower tax costs) than index mutual funds. For a taxable account, should I prefer to hold ETFs?

Answer: There is a widely held belief among investors that exchange-traded funds (ETFs) are inherently more tax-efficient than mutual funds and therefore should be favored in taxable accounts. There is a sound reason for this belief which is the fact that due to their structure which facilitates in-kind creation and redemption of shares, capital gains taxes should only be incurred upon the sale of the ETF. Mutual funds, on the other hand, incur capital gains distributions, and they can even occur in years when the fund had a negative return.

Index Fund Advisors has long maintained that the tax benefits offered by ETFs do not necessarily exceed those offered by tax-managed index funds. Although Morningstar classifies all tax-managed funds as actively managed, we believe that funds that are designed to passively capture the returns offered by a particular segment of the market may incorporate an additional layer of tax-management, which does not render them active. Tax-management may come in the form of minimizing capital gains or harvesting losses when shares are sold, and it may mean avoiding companies with high dividend yields.

Currently, IFA utilizes DFA tax-managed funds in the implementation of the IFA Index Portfolios for five different asset classes:

1)      US Large Blend

2)      US Large Value

3)      US Small Blend

4)      US Small Value

5)      International Value

The chart below shows how the DFA tax-managed funds compare in tax costs to ETFs provided by Vanguard for the four domestic asset classes and by iShares for the international value asset class, where Vanguard does not offer an ETF option.

Being somewhat surprised by these results (especially for the four Vanguard ETFs), we dug a little deeper and found this article from Morningstar which offers a potential explanation of Vanguard’s unique ETF structure (where the ETF is simply an additional share class of a pre-existing mutual fund) as a possible (but unproven) contributor to higher tax costs. Even if we replace the four Vanguard ETFs with the most tax-efficient iShares funds, we would only obtain a lower tax cost in two of the four categories, and the amount of the tax savings would be .03% for one and .08% for the other.

As we have always said at Index Fund Advisors, the goal for a taxable investor is not to minimize his taxes but to maximize after-tax returns. We have yet to see investment vehicles that provide a higher probability of meeting this goal than the DFA tax-managed funds.