Maybe not. ETFs can help you avoid the taxman, but keep an eye on out for special situations.

    Capital gains distributions. Dividend taxes. 1099s.
    The very words send a shiver down the spine of prudent investors. Or at least they should: According to John Bogle of Vanguard, the average investor in an actively managed mutual fund forfeits 2.2% each year to taxes. Index funds do better, taxing the average investor just 0.9% per year. But still, it adds up.
    A First Quadrant study published in 2000 found that $1,000 invested in the Vanguard 500 Index Fund in 1980 would have grown to $24,000 on a "pretax" basis over 20 years. Take out taxes on capital gains distributions and dividends, however, and that number shrinks to $16,200.
    For active fund investors, the story gets worse. According to the First Quadrant study, the same $1,000 invested in the average actively managed fund in 1980 grew to just $19,600 pretax over 20 years. After you account for taxes on capital gains distributions and dividends, the net return dips to $11,300. In other words, taxes ate up $8,300 in returns on a $1,000 investment.
    What's amazing is that these numbers only include distributions and dividend taxes from the fund itself-you know, the little numbers on those innocuous 1099 forms. The capital gains that investors pay when they ultimately sell their funds are extra.
    You may not have heard much griping about taxes lately, because distributions have been at record lows. In the aftermath of the Internet bubble, many funds were able to harvest losses and shield investors from capital gains. As a result, mutual fund distributions fell from a record 6% of assets in 2000 to less than 0.3% of assets in 2003. But that number is creeping up: Funds paid out $155 billion in capital gains in 2005, according to the Investment Company Institute, up from just $55 billion in 2004. And that number will rise again in 2006.
    Moreover, with dividend payouts increasing, investors are beginning to learn the hard way that Uncle Sam doesn't treat all dividend income the same, and that the dividend tax bite can hurt, too. In other words, taxes are starting to matter again.

Enter ETFs
    What's an advisor to do? Well for starters, you should take a close look at exchange-traded funds (ETFs).
    ETF designers have been crowing about the tax efficiency of their funds since the first ETF launched in 1993. Traditional mutual fund companies have disputed that claim vigorously, but the data is increasingly on the side of ETFs. A recent study by Morningstar found that "the vast majority of domestic and international ETFs with five-year records ranked in the lowest half of their respective categories and broad-asset classes [for tax-cost ratio]." Most ETFs have never paid a capital gains distribution, and although traditional index funds have been very tax efficient recently, over the long haul, ETFs have the edge.
    Here's why: When individual investors sell shares in an ETF, they don't redeem them directly from the fund. Instead, they simply sell them on the open market. The sale has no impact on the holdings of the fund, so there is no possibility for capital gains. In contrast, when a mutual fund shareholder redeems shares, the fund must sell stock to raise cash and pay that investor.
    ETFs still can create capital gains when the index they track is rebalanced, or when a component is acquired. But even here, ETFs have an advantage. That's because Authorized Participants-the big boys who help create liquidity in ETFs-create and redeem ETF shares directly from the fund manager, in what's called an "in-kind transaction." If they hold 50,000 shares of an ETF, for instance, they can return those shares to the ETF manager and receive shares of the underlying stocks in return.
    When this happens-and it happens a lot-the ETF manager gets to choose which shares to deliver. The folks who run these things are not dummies, so they deliver shares with the lowest cost basis. It doesn't matter to the Authorized Participant-they pay taxes on their own cost basis-but for the fund, it's a huge win. Over time, they can slowly but surely get rid of any "capital gains overhang." As a result, when the fund is forced to sell shares during a rebalancing or as the result of a takeover, they have all high-cost lots to choose from.
    Traditional mutual funds don't have that option: The Vanguard 500 Index Fund, for instance, is sitting on unrealized capital gains equal to 27% of the fund's value as of year-end 2004. By comparison, the world's largest ETF, the SPDR (SPY), which tracks the same index, had an unrealized capital loss equal to 20.7% of the fund's value, according to an article, "The Anatomy of Tax Efficiency," by Gary Gastineau in the May/June 2005 issue of the Journal of Indexes. Vanguard is a superb manager of capital gains, and has so far managed to avoid paying out capital gains. But if the current bull market continues, the arithmetic will get tough.
    "Obviously, we like redemptions, because we're pushing out the stock with a lower cost basis in our portfolio," says Tim Meyer, business line manager for ETFs at Rydex Funds. "That helps the overall tax efficiency of the ETF."
    How well does this work? Very well. Barclays Global Investors (BGI), which manages the lion's share of U.S. ETF assets, has delivered zero capital gains on any of its funds-that's 101 funds with $160 billion-plus in assets-for the past five years. And BGI isn't the only one: Rydex (nine ETFs), PowerShares (36 ETFs) and Vanguard (23 ETFs) all paid out zero capital gains in 2005; State Street Global Advisors, the second-largest ETF manager, posted small distributions for just 3 of its 31 funds last year.
    BGI's Berg says that sustaining zero capital gains over the long haul might prove impossible, especially in sectors that experience huge run-ups followed by severe pullbacks. If oil or housing stocks tumble in the next few months, for instance, watch out.
    It also pays to watch out for the newer ETFs. According to Meyer, "[I]t's more difficult for newer ETFs to manage capital gains, because they don't have enough redemption activity to pass on the highest-cost shares outside the fund."
    Meyer says that Rydex was almost forced to pay a distribution on its Rydex Equal-Weight Fund (RSP) in 2003, its first year on the market. The fund actually sold some losing components specifically to offset gains on its books, risking a small tracking error to avoid the distribution. "We only actively manage for capital gains," says Meyer. "We do not actively manage to outperform."
    The case of RSP points out just how effective the ETF methodology is in preventing capital gains. RSP holds all 500 stocks in the S&P 500 index, but it holds them at equal weights. To maintain that weighting, the fund is rebalanced every three months, selling the 250 stocks that have performed well and buying the 250 stocks that have performed perfectly. It's the perfect recipe for capital gains, especially with turnover that reached 55% last year. But despite three consecutive years of solid returns (22%), the fund has never made a capital gains distribution. That may not be sustainable for the long haul, but it is impressive.

Don't Forget About Dividends ... And There Are Differences
    Here comes the "Yes, but..."
    Capital gains get all the press, but the truth is, they are only one-half of the story. The dividends you receive from funds also get taxed, and here, ETFs don't always fair so well.
    The 2003 dividend tax cut lowered the tax rate on dividend payments from a maximum of 35% to just 15%. But in order to qualify for this tax rate, dividends must be "qualified": You (or your fund) must hold the stock paying the dividend for 61 days, most foreign dividends are excluded and REIT income is excluded. There are other ways that funds can run afoul of the "qualified dividend" (or "QDI") rules, such as by loaning out shares for securities lending. But these are the basics.
    ETFs experience a lot of "velocity," with asset counts rising and falling by huge numbers on a weekly basis. With all this movement, the funds sometimes run afoul of the 61-day holding period.
    "It's still a relatively new feature of the tax code, and it's one that people aren't accustomed to," says Paul Lohrey, principal with Vanguard's Quantitative Equity Group. "Most investors are accustomed to looking at capital gains distributions as the determinant of tax efficiency, but unfortunately, it's a little bit more complicated than that."
    The issue raised some eyebrows in 2004 when the iShares Dow Jones Select Dividend ETF (DVY), a fund created to capitalize on the 2003 dividend tax cut, paid out 28 cents of nonqualified income as part of a $1.91/share dividend payout. That shaved about ten basis points off of the after-tax return.
    In 2005, fund managers seemed to be more aware of the dividend issue, and they managed the problem much better. DVY, for instance, posted 100% QDI for the year, as did many other ETFs.
    But some funds weren't so lucky. The iShares Russell 2000 Index Fund (IWM), for instance, paid out half of its distributions as nonqualified income, largely because the Russell 2000 Index includes REITs. Foreign funds struggled as well, with funds like the iShares S&P Europe 350 Index Fund (IEV) paying out 41% of its dividends as nonqualified gains.
    The net impact of these distributions is small-a tenth of a percent here, 15 basis points there. But it adds up. And with dividend payouts rising-they're up 36.5% from 2003-2005-it is an issue to consider.
    It's too early to say whether ETFs are truly disadvantaged here. But because mutual funds tend to have more long-term investors with longer track records, they are more likely to meet the 61-day standard.
    "If you look at a fund with conventional share classes, mutual fund complexes encourage holders to be long-term investors," says Lohrey. "We police against [short-term trading], as do other fund complexes. There tends to be less velocity ... and so a higher proportion of the dividends will meet the QDI test."
    Deserving special attention is the issue of REIT income, because it's not clear that investors understand it has negative tax implications.
    Consider this: As of May 3, the iShares Dow Jones U.S. Real Estate Index Fund ETF had an effective yield of 3.68%. Since this income is non-QDI, for a high-net-worth investor the after-tax yield is 2.39%. By comparison, the iShares dividend ETF mentioned earlier yields 3.57%, or 11 basis points less than the REIT fund. But last year, 100% of that payout was QDI. If that stays the same in 2006, the effective after-tax yield is 3.12%, or 49% higher than the REIT.
    One other special situation is silver and gold bullion ETFs. More than $7 billion is tied to the gold ETFs, and the iShares-sponsored silver ETF attracted nearly half-a-billion dollars in its first week of trading. Investors may not realize, however, that these funds are tax disadvantaged. According to the IRS, gold and silver bullion are "collectibles," not "investments," and as such are subject to a 35% capital gains tax.
    Although gold and silver mining companies are not perfectly correlated with the price of bullion and come with the risks of corporate mishaps, the tax situation makes them worth considering. A gold mining ETF is in the works.
    Taxes are the naked emperor that the mutual fund industry does not like to mention. Of course, investors need to look beyond taxes. They also should consider transaction costs (critical for ETFs), loads, expense ratios and internal portfolio turnover.
    Moreover, there continues to be substantial debate about how tax efficient ETFs truly are, and dividends do pose a threat. A recent study by Lipper Associates pointed to ETFs' relative inefficiency with dividend income to argue that traditional index funds might be better. Maybe. But with a bull market entering its fifth year and more funds facing cap gains overhang, it's a risk I might be willing to take.

Matthew Hougan is assistant editor of Journal of Indexes.