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Since the introduction of the first U.S. exchange-traded fund (ETF) in 1993, ETFs have exploded in popularity, growing to between 25% to 30% of U.S. equity trading volume.[1]
We can see why: ETFs allow investors to quickly and easily diversify their investments with one simple purchase. It’s also why mutual funds were so popular when they were introduced.
ETFs have one significant advantage over mutual funds: general tax efficiency.
But ETFs have one significant advantage over mutual funds: general tax efficiency. While ETF investors will still owe taxes on capital gains, they’re less likely to be hit with surprise taxes than mutual fund investors, and the taxes they do owe should largely result from their own trading decisions.
Fewer taxes AND more control.
So, how does it actually work?
An Efficient Structure...
The tax efficiency of ETFs comes from their structure, and specifically how they’re structured differently than mutual funds.
Mutual funds are cash-based. Investors buy into the fund with cash, the fund manager uses cash in the fund to buy the underlying securities, and then the fund manager issues shares to investors according to the cash they sent.
Because of this cash-based method, when a mutual fund manager sells securities to rebalance the portfolio, or to raise cash to cover fund redemptions, that selling decision can generate capital gains for the fund’s shareholders—and thus capital gains taxes.
By contrast, ETFs are unit-based. ETFs are run and managed by an issuer, who buys the shares of the underlying securities and places them in a trust. Then, they issue shares of the trust—and that’s what investors buy in the form of an ETF.
The issuer uses a system called “creation and redemption units” to handle inflows into the fund, as well as shareholder redemptions. Simply put, when buyers want to purchase more shares than there are available to buy, the issuer creates a block of shares, usually 25,000 at a time, to provide shares for buyers to purchase.
The same thing happens in reverse for redemptions. If there aren’t enough shares for sale to fulfill a sell order, the issuer will create “redemption units.” This process results in fewer internal capital gains that could be passed on to shareholders, because the issuer isn’t selling the underlying securities in the ETF (the trust); instead, the issuer is redeeming units of the trust in total. This mechanism is what makes ETFs generally more tax-efficient than their mutual fund counterparts. [2]
[1] ETF.com. “Why Are ETFs So Tax Efficient?” Accessed August 4, 2024.
[2] Fidelity. ETFs vs. Mutual Funds: Tax Efficiency Accessed August 4, 2024.
Who’s Who in ETFs
The issuer creates, registers, and manages the ETF. It's the name on the ETF itself—think Blackrock, Vanguard, or WisdomTree. For our flagship ETF, the Motley Fool 100 Index ETF (TMFC), it's Motley Fool Asset Management.
The investment advisor makes the decisions about which investments to buy or sell in the fund. They execute the fund’s philosophy. Yep, for TMFC, it’s Motley Fool Asset Management, and we call them Portfolio Managers.
The custodian holds the underlying securities on behalf of the issuer. They handle trade processing, settlement, custody, and clearing, and they manage the money that goes in and out of the fund. For TMFC, it’s US Bank.
The distributor underwrites creation and redemption units, contracts with authorized participants to distribute the ETF, and approves all creation and redemption orders. In short, distributors are the entities that make the primary market activity possible, enabling the secondary market where individuals or advisors purchase the ETF. For TMFC, it’s Quasar.
The administrator and transfer agent handles most of the back office support for the fund, including accounting, pricing the security, creating annual reports and prospectuses, and calculating the net asset value (NAV) every market day. For TMFC, it’s US Bank again.
...And More Control
In the case of both mutual funds and ETFs, you, the fund holder, will generate capital gains or losses within your individual portfolio when you decide to sell your shares (just as you would with any security). Whether those capital gains are taxed at the short-term rate or the long-term rate depends on how long you, the investor, held your shares.
But, on top of the capital gains tax an investor might owe from selling the fund shares, mutual fund holders may likely ALSO be subject to capital gains taxes when the fund manager sells underlying investments, whether to redeem sells or to reduce or close a position they no longer believe in (that aren’t balanced by capital losses). Whether those capital gains taxes are short- or long-term depends on how long the fund held those underlying investments.
In other words, in addition to generally having fewer taxable events, ETF fund holders get to decide when those tax events, namely, capital gains, occur, making it easier to plan and execute a tax strategy.
The Tax Efficiencies of TMFC
We used to sell mutual funds. In fact, when Motley Fool Asset Management began, that’s all we sold.
In 2018, we launched our first ETFs, and we were so impressed by the benefits of the ETF structure—the low fees, the accessibility, the tax efficiency—that three years later we decided to convert our existing mutual funds into ETFs.
Our flagship ETF, TMFC, tracks the top 100 stock recommendations from the team of analysts at The Motley Fool, LLC. Our buy-to-hold orientation lends itself to a lower turnover mentality, and a mechanism called custom baskets helps to reduce taxable events further.
Our “Foolish” philosophy: buy to hold
The Motley Fool, LLC, our parent company and the creator of the proprietary Motley Fool 100 Index, believes in the investor philosophy of aiming for long-term returns by buying and holding what they believe are high-quality businesses with lasting competitive advantages, healthy balance sheets, high profit margins, and attractive returns on capital. In other words...
“Foolish” investors don’t trade—they invest.
Day to day, even quarter to quarter, market movements aren’t necessarily relevant to long-term investing goals and gains over time, which means the analysts at The Motley Fool, LLC aren’t simply reacting to market sentiment. They’re positively choosing companies they believe in. And we make those companies available to investors through the Motley Fool 100 Index ETF (TMFC).
Why does that matter to our ETFs?
Because a buy-to-hold orientation can generate lower frictional costs than strategies with high churn. An ETF could have high churn, for example, if an index has more frequent or more dramatic composition changes than the Motley Fool 100 Index typically reports or from factor-based strategies that change holdings frequently.
Lower frictional costs mean fewer taxable events.
Custom baskets
Every quarter, the Motley Fool 100 Index is adjusted to account for new recommendations, market movements, and other changes. Thus, every quarter, TMFC has to be rebalanced in order to accurately track the index.
This means that every quarter, TMFC’s Portfolio Managers will buy companies that have been added to the index and sell the ones that have been removed. They’ll also rebalance the weightings of certain holdings if they grow above or fall below their appropriate level, bringing them back in line with the index.
Rebalancing creates taxable events for mutual funds and ETFs alike, in the form of capital gains and losses.
Our Portfolio Managers use a mechanism called custom baskets to reduce the tax consequences of that rebalancing.
Here’s how it works. When the Portfolio Managers compile all of the transactions they’ll need to execute to rebalance the portfolio, they look to see if the unrealized gains outweigh the unrealized losses in those transactions. If they do, the Portfolio Managers use custom redemption baskets to remove positions with large unrealized gains via an “in-kind” transaction—which is not a taxable event. This reduces the unrealized gains until they’re balanced with the unrealized losses, creating a tax-neutral situation.
In-Kind Transactions, Explained
When an individual fund holder sells shares of an ETF or any other security, they essentially give back the shares and receive cash in return. When an ETF issuer needs to remove positions, they can use an in-kind transaction instead.
In an in-kind transaction, the issuer doesn’t actually sell the underlying securities. They give the distributor the shares they want to redeem in return for a basket of securities held by the ETF.
Imagine an ETF with stocks A, D, Q, R, and Y. The issuer wants to remove position R, because it’s no longer in the index. Instead of selling shares of R for cash, the issuer gives the distributor all its shares of R, and in return the distributor gives the issuer the equivalent value of those shares via a basket of shares of A, D, Q, and Y.
The issuer has rebalanced the portfolio, but because there’s no cash exchanged, there’s no taxable event. These in-kind transactions are a fundamental feature of ETFs.