Are ETFs really more tax efficient than mutual funds?

    ETF managers have long promoted the tax efficiency of ETFs. The assertion that ETFs are more tax efficient than traditional mutual funds has been largely unchallenged, but also undocumented. Only now have most ETFs had the five years of track record (through both bullish and bearish markets) that are really necessary for us to make any legitimate comparisons.
    If you're looking for the greatest amount of data, the best index to look at is the S&P 500. So it was appropriate, I thought, that some recent Morgan Stanley equity research strategist (Paul Mazzilli's group) chose this index to make the distributions comparison.  I looked at the Morgan Stanley data, found it shocking, as might many investors. But comparing SPDRs (or iShares' S&P 500 fund, IVV, for that matter) to the field of S&P 500 index funds with expense ratios ranging to over 200 basis points (2%) is a bit like comparing the Yankees and Red Sox to every other baseball team in the country, from the major leagues down to tee ball.
    In fact, if we compared, say, Vanguard to the field of S&P 500 funds, we might get similarly skewed results to the Morgan Stanley data. In Figure 1, I've done just that. The first two columns are from Morgan Stanley, and compare the capital gains distributions as a percentage of NAV of the SPDR ETF (SPY) to the "Average Open-End S&P 500 Index Fund." The third column is my addition, and includes the same data for the Vanguard 500 (the Boston Red Sox, if you will, of open-end S&P 500 funds).

    You would be correct to point out that the derogatory expense ratio comment in the above Yankees/Tee Ball comparison should have little to do with capital gains distributions. So why does the average S&P 500 index fund look so different from the Vanguard 500? In a word, mismanagement; essentially, most index funds are overly passive in how they handle cash and shares. And keep in mind that we haven't witnessed heavy redemptions during the above period. In an environment of heavy redemptions, even a well-run traditional mutual fund would suffer.
    When traditional funds see significant net fund redemptions from investors, the fund must pay capital gains on the shares that have been sold to pay back the investors. I don't believe the Vanguard 500 has ever had a year in which it has suffered net redemptions, as Vanguard investors tend to be the buy-and-hold type. Thus all or most of the capital gains distributions in the Vanguard funds have been the result of index changes: When companies go out of the S&P 500 (which has around 10% turnover a year, normally), those shares must be sold and taxes must be paid on any gains. So why zero gains in recent years for Vanguard? The fund has realized losses from the same mechanism. And it must be said that the very time that traditional funds are most likely to suffer a wave of redemptions is likely also the time they are most insulated from capital gains, with realized losses compensating for gains.
    So in short, in an environment that was about as bad as it could get (with enormous gains taken by funds in the 1990s go-go years followed by a hard turn in 2000 and 2001), the worst of it for the Vanguard 500 was a 63-basis-points tax distribution (16 basis points of it short-term gains) at the end of 1997. And it's not too hard to do the math on that. In 1997, capital gains rates stood at 20% for those in the top tax brackets and 10% for those in lower tax brackets. In 2003, those numbers changed to 15% and 5%, respectively. So in its rawest form, even under the higher tax regime, the 1997 distribution cost wealthier taxable Vanguard 500 investors about 14 basis points of returns. And in the current tax environment (see assumptions below), that number would be closer to 9.5 basis points.
    Most important, the proof is in the pudding. And I like vanilla, but with a little cinnamon on top. Vanguard (as well, increasingly, as SPY and IVV) manages its index funds with the cinnamon of good cash flow and index-effect management. It all comes down to what you make in the end. And Gary Gastineau, formerly of the American Stock Exchange and Nuveen, and now at ETF Consultants, has long held that the tax efficiency of ETFs should on average give them about a 50-basis-points annual edge for taxable investors. Let's put this to the test.
    I began looking at these numbers, just thinking that I would use Morningstar's numbers for pre- and post-tax returns at ten-year annualized levels (available for S&P 500, SPDRs [SPY] and the Vanguard 500); and the five-year pre- and post-tax annualized returns for many of the other asset classes. But on reviewing the data ... while Morningstar does show us numbers, some of them suffer from clearly missing or erroneous data that has skewed the post-tax numbers. Not to mention that they show the effect of total distributions (including dividends).
    For our purposes, we'll keep it simple and just look at year-end capital gains distributions as a percentage of fund NAV, and use an assumption of the 28% tax bracket for short-term distributions (to which we'll assign the 14.3% average rate that taxpayers in the 28% bracket actually pay, according to the above-referenced Center on Budget and Policy Priorities study). And for long-term capital gains, we'll just use the current higher 15% rate. In fact, lets just make it 15% for all capital gains distributions, the bulk of which are long-term capital gains in any event. Figure 2 shows ten years of ETF and open-end mutual fund data for funds tracking the S&P 500.

A Look At The Supposed Poster Boy For Bad Traditional Index Fund Capital Gains Performance
When we take a look at the small-cap space, the picture is not quite so rosy. Vanguard famously took a couple of huge capital gains hits on its Russell 2000 fund in the early 2000s. Direct comparison to ETFs is a bit imprecise in this space because 1) The Vanguard small-cap fund had a much longer track record and much more time to build up capital gains, and 2) The Vanguard fund switched benchmarks from the Russell 2000 to the MSCI Small Cap Index in May of 2003, making direct returns comparisons difficult from that time forward. Nonetheless, reading over the years of data thus far, in up and down markets (and you can see every single iShares distribution on one page on I do think it's safe to say that ETFs would be highly unlikely to pay out these sorts of capital gains except in very exceptional circumstances (like the iShares MSCI country funds, which have sometimes been forced to pay out enormous gains because of having to comply to diversification regulations that force large annual rebalances). Figure 3 shows the small-cap data.

    For our first segment of data, covering the S&P 500, the index with the longest history both for ETFs and mutual funds, the results show that in the case of the granddaddy of all ETFs, and the granddaddy of all mutual funds, that the tax issue is overwhelmed by other factors in the index management process. And the end result is that SPDRs, which is basically free of capital gains distribution, gains a couple basis points annually on the Vanguard fund but still trails in performance despite the Vanguard 500's higher expense ratio (18 basis points as opposed to the SPDRs ten basis points, which was actually 12 basis points for all or most of this time period). We've inserted the date for the iShares S&P 500 fund (IVV) for interest, because it is an open-ended mutual fund (unlike SPDRs, which is a trust) and has a bit more flexibility in terms of share lending and use of derivatives. We show only total returns for IVV, but they've also only paid one small capital gains distribution in their history.
    Also included in Figure 2 is the effect that the average S&P 500 index fund capital gains distribution  (and mind you SPY, IVV and VFINX are not average funds in any sense) would have had on return even under the current tax regime. And the numbers, like the expense ratios of many of these funds, are truly scandalous. And of course the effect of losing that 50 or 70 basis points of return in one year, less an expense ratio likely to be in the same ballpark or higher, compounds over time.
    When we move to the small-cap space, even the Vanguard funds take a mighty capital gains hit, while as yet ETFs have shown no significant capital gains payouts. This result must be looked at cautiously, because of the relatively brief comparative track record of the small-cap ETFs, but looking through reams of distributions data, we are convinced that ordinary ETFs in this space (which have reasonable levels of assets and at least some creation and redemption activity) would be unlikely to ever be subject to a capital gains payout of this size.
    The verdict: ETFs that can be directly compared to equivalent traditional index funds do enjoy a tax advantage. The onset of ETF and ETF share classes can only mean good news for investors, who can now add in a factor of increased tax efficiency of ETFs in addition to other factors such as expense ratio and fund management/tracking error in selecting funds. The reality is that with the exception of their peculiar country funds (formerly WEBs) and 2000, when many of their funds had distributions owing to difficulties in managing tax lots during the introduction of the funds/seeding process, the iShares have really paid no tax distributions in their five-year history. And the result with the SPDRs is the same.
    ETF industry experts have warned of the tax overhang issue in traditional funds, and have asserted that ETF tax efficiency can be expected to gain 50 basis points of returns a year. It does seem clear that in the case of a direct comparison to the Vanguard 500 fund to SPY and IVV, this advantage is overstated. The late 1990s had overhang the likes of which we may never see again in the S&P 500, and it really came to not much of anything for Vanguard investors. Vanguard Small Cap investors, however were not so lucky. Overall, the data indicates that other factors, such as expense ratio and especially fund management, can completely overwhelm the tax benefit in some instances, but the long-term tax advantage of ETFs does seem clear. We'll continue to monitor the data, and we're pleased that competition has forced fund managers to pay attention to the issue.

Jim Wiandt is editor of the Journal of Indexes and publisher of Exchange-Traded Funds Report and He is author of the book, Exchange-Traded Funds, published by John Wiley & Sons.