How to Assess the Tax-Efficiency of a Fund

By Ellen Sheng September 18, 2020

This is Part 5 of Financial Advisor IQ’s five-part special report on how financial advisors can help their clients manage the tax impacts of their portfolios.

Exchange-traded funds have become very popular in recent years both because of their lower cost base and their tax efficiency. Some advisors stick exclusively to ETFs for these reasons. 

But there are times when clients or advisors want mutual funds, either for active management or exposure to a specific niche. Advisors can minimize the tax impact by putting these less tax-efficient investments in more tax-efficient vehicles. Tax-loss harvesting also plays an essential role in overall tax management. 

Maximizing advantages    

While ETFs are largely more tax-efficient, it’s helpful to examine some of the reasons why to maximize their benefits. From a tax perspective, ETFs have a couple of structural advantages.

First, ETFs tend to have a lower turnover, which triggers fewer capital gains. By comparison, actively managed mutual funds typically have more turnover and thus more realized capital gains, which are taxed. 

The other advantage lies in the way ETFs distribute and realize gains. ETFs use an intermediary to buy or sell shares. If the fund is growing and needs to add more shares, it buys through the intermediary. Similarly, if the ETF needs to sell some shares, perhaps because of some change in the index, it sells through the intermediary. This is called redemption-in-kind (or in-kind-redemption) and does not trigger taxes. 

Mutual funds have been watching this tax advantage, and some have tried structuring more like an ETF, buying and selling through an intermediary for tax efficiency.

Robert Elwood, partner and co-founder of law firm Practus, has been working with one fund company that is trying to adopt an ETF-like structure. 

“It sounds super easy. Structurally, it would be an ETF that acts much like mutual fund — except there is public trading and no redemptions at [the] end of [the] day. But it turns out to be surprisingly tricky to achieve that,” he says.

Most of the challenges lie with SEC reporting requirements, but Elwood says he is optimistic that a mutual fund with a more tax-efficient structure is coming in the near future. 

Mutual funds also have distributions, which are taxed. A client could be holding on to a mutual fund that’s shown negative returns and get a distribution that would be taxed.

Dean Mioli, director of investment planning at SEI, worries that capital gains distributions could be fairly large this year. Equities markets have seen a 10-year bull streak, and many mutual funds have been holding on to positions that have seen huge gains. Funds that sell some of these shares typically sell the more liquid positions, such as what’s referred to as the FAANG stocks —  Facebook, Amazon, Apple, Netflix and Google (Alphabet) — or the Dow 30 largest stocks. The result could be a hefty capital gains distribution. 

Mioli suggests investors examine any mutual funds with big long-term gains when reviewing 2019 client tax returns and any capital loss carry forward. If it looks like there will be a large capital distribution, it may make sense to sell the shares before the distributions are paid.  

Comparing mutual funds  

While ETFs are generally more tax-efficient, not all mutual funds are the same.

Mutual funds that don’t pay dividends are more tax-efficient than mutual funds that do pay dividends. Also, some mutual funds are more active than others. Funds with a buy-and-hold strategy that invest in growth stocks or long-term bonds are likely to be more tax-efficient as long-term gains are taxed at a lower rate than short-term gains. 

In addition, it matters what mutual funds invest in. Funds that invest only in government or municipal bonds — which generate interest but are not subject to federal income tax — are called tax-free funds. 

Advisors can check the prospectus and look for the after-tax returns. Also, when comparing two mutual funds with similar performance, advisors can check Morningstar for potential capital gains exposure. The one with lower capital gains exposure will mean lower taxes. 

The results could be eye-opening. Sometimes the tax cost on capital gains can be higher than the expense ratio of the fund.  

“You can bring more awareness to after-tax returns of an investment once you start looking at that,” says Rey Santodomingo, managing director of investment strategy at Parametric, a Seattle-based asset manager.