WILL ACTIVE ETFS KILL MUTUAL FUNDS AND HEDGE FUNDS FOR TAXABLE INVESTORS?

Evolution Trading writes: Meb Faber did a post back in 2012 on Why Active ETFs spell doom for Active Mutual Funds covering after tax return benefits of active ETFs.

More recently Wes Gray at the Turnkey Analyst Blog has a post Why ETFs are more tax efficient than mutual funds.

Basically, the redemption and creation process of ETFs allow low basis stock to be exchanged for higher basis stock thus effectively removing the taxable gain.  Also, ETFs may be able trade (or technically exchange) one position for another and avoid creating a taxable “trade”.

Dividends received by an active ETF must be distributed so there is no tax benefit.

For taxable investors utilizing active managers in mutual and hedge funds this could be a game changer. Why you ask?

To demonstrate I created a chart to compare returns across an active mutual fund,  a hedge fund and an active ETF.

I present a mutual fund and hedge fund that have:

1. all returns taxed as short term (39.6%)
2. 60% of returns taxed at the long term rate(39.6%) and 40% of returns taxed at the short term rate (20%)

I compare this to an active ETFs that has its dividend taxed at short term capital gains, but does not distribute any other capital gains.

The top charts show that at a 15% return the after tax return of an active ETF is 11.95% and the hedge fund/mutual fund range from5.89% to 8.85%.

The active ETF returns are 35% to 102% more!

The bottom charts show what each strategy has to return to equal the return of the active ETF. A hedge fund would have to return between 23.85% to 28.40% to equal the same return as the ETF.

Within the ETF structure you may be able to effective compound tax free (excluding dividends). This would result is significantly greater wealth.

Starting with $100 the active ETF is worth (assuming the returns from the previous chart) $309 with the 60/40 active mutual fund next at $233 – which is a 32% increase in wealth. The worst is the active hedge fund at $177 – the active ETF creates 74% greater wealth at the same return level.

While the growth of the ETF market has been in index/smart beta ETFs, the real benefit of the ETF structure is for the active manager who may be able to turn short term strategies into tax deferred vehicles.

We believe the long term opportunity for managers and taxable investors is enormous.