Can Investing in ETFs Reduce Your Tax Bill?

by Tom Madell

Recently, a very long-time reader of this Newsletter posed an interesting question: In choosing a fund for a taxable account, should one lean toward an ETF over a mutual fund with a similar objective? Why? Because of the near absence of long-term capital gain distributions in ETFs resulting less taxes to pay and therefore a better outcome.

For those who might be attuned to the matter of taxes on funds, you will already be aware that most mutual funds distribute dividends as well as short- and long-term capital gains. This means that for each distribution, your tax bill will typically go up. However, if you invest in indexed mutual funds, as opposed to ones that are actively managed, the capital gains, if any, tend to be much less because hardly any investments in the portfolio are being sold in any given year. But, either way, you will still have about the same amount of dividends to pay taxes on. Of course, within a non-taxable account such as a 401(k), none of this is particularly relevant since you only pay tax sometime in the future when you withdraw money.

Most ETFs are really just a type of index fund and so, in general, such ETFs should also tend to have low capital gains distributions as compared to managed funds. So it might appear that one should always pick either index funds or ETFs within their taxable account. But not so fast.

While picking ETFs and index funds does make a lot of sense for investors who wish to minimize their tax bill, one still needs to consider whether such an ETF/index fund is really going to come out ahead in the long run as compared to an excellently managed fund.

Here is an example. Suppose you are able to identify a managed fund with an excellent track record, one that has, over a significant stretch of time, outperformed a particular benchmark index such as the S&P 500. While generally few and far between, there are some funds, guided by excellent long-term managers, who have often shown such market-beating propensities. While not guaranteed of outperforming in any given year, you might still have confidence such a fund will do better than the S&P 500 over the next few years.

One such a fund might be T. Rowe Price Blue Chip Growth (symbol:TRBCX), a fund I came across in a listing of funds that currently have the most assets. With the same fund manager, it has beaten the S&P 500 when held over 15, 10, and 5 year periods.

But even assuming this fund can continue this outperformance, how well has it done when taxes resulting from distributions are taken into account? One can answer this question by referring to morningstar.com under the "Tax" tab after entering the fund's symbol. According to information displayed there, even after maximum bracket yearly taxes are taken out, one would have lost only a little less than 1/2 of 1% to taxes per year (0.41%) on average over the last 5 years for a post-tax total return, that is, tax-adjusted, of 11.31% annualized. This compares favorably to investing in the Vanguard 500 Index Fund, the Vanguard 500 ETF, or even the Vanguard Growth ETF (VUG), which had tax-adjusted ann. returns of 9.33, 9.45, and 10.22% respectively. (Data as of the end of February.)

Clearly, then, one cannot argue that the investor who chose this fund would have been better off by selecting an alternative fund, merely because it was an index fund, or even an ETF.

While the great majority of managed funds will not stack up as well as TRBCX, it goes to show that a good performing managed fund, frequently managed with an eye to keeping long-term capital gains distributions low, can at times be a better choice than either an index fund or an ETF.

Now if we had picked another T. Rowe Price fund for the above example, US Large-Cap Core (TRULX), it would seem we made a good choice as well. It has too has beaten the S&P 500 by a small amount when held over the last 5 years under the same manager, although largely as a result of its performance in 2015.

But this fund, like many managed funds, distributes gains every year, typically many of them long-term capital gains. As a result, over the last 5 years it has lost approximately 1.5% more than its reported pre-tax performance per year when the investor factors in the maximum yearly taxes resulting from these distributions. Thus, the tax-adjusted return now no longer outperforms the return from either the Vanguard 500 Index Fund or the Vanguard 500 ETF.

But getting back specifically to ETFs, it is often true, as mentioned above, that due to how they are structured, there may be very few long-term capital gains distributed to investors as compared to a managed fund, or even an index fund that is not an ETF. So, should an investor pick an ETF solely for this reason?

On paper, this might appear to be true. But, since most broad-based index funds themselves distribute very few long-term capital gains already, there would appear to be little advantage to picking an ETF over an index fund on that basis alone. But when considering more narrowly defined funds such as a sector fund, the ETF might have a clear advantage. That is, while the managed sector fund might have its tax-adjusted return reduced significantly by these distributions, the ETF likely wouldn't.