Over at Bogleheads we came across the following discussion: Is ETF more tax-advantaged than mutual funds?
by wang.zhen » Sun May 18, 2014 3:32 pm
Hi,
I'm a newbie in personal investment.
Recently I'm considering to create a Vanguard investment account.
There are some recommendations on fund selections following the three fund portfolio.
I get it that -- to build up a three fund portfolio, i can use either mutual funds or ETFs.
However, I do not really understand the differences between ETF and mutual funds.
It seems that ETF are more tax friendly than mutual funds according to the following link.
There gotta be some "down-side" for ETFs, right? Otherwise why not everybody selects ETFs?
Any suggestions on how to select between ETFs and mutual funds?
Thanks very much for your time and your help.
Regards
Zhen
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Re: Is ETF more tax-advantaged than mutual funds?
by ogd » Sun May 18, 2014 4:10 pm
Zhen: see our Wiki on the topic, including the Vanguard specific section: http://www.bogleheads.org/wiki/ETFs_vs_mutual_funds
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Re: Is ETF more tax-advantaged than mutual funds?
by wang.zhen » Sun May 18, 2014 4:24 pm
Thanks:)
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Re: Is ETF more tax-advantaged than mutual funds?
by retiredjg » Sun May 18, 2014 4:41 pm
From your link....
ETFs. The lower cost alternative to mutual funds is also far more tax efficient. With most ETFs still tracking indexes, portfolio turnover is limited, as are capital gain distributions to investors (now taxed at a higher 20 percent rate for investors with more than $400,000 in annual income).
Taxes on gains in ETFs are due when investors sell the funds, giving them a significant tax-deferral advantage over mutual funds. "Investors don't have to incur the huge tax liabilities that mutual funds can cause," Edelman said.
With the explosion of new offerings in recent years, ETFs now give exposure to a huge variety of markets and investments. Long a favorite of financial advisers who like the low-management fees, their better tax profile versus mutual funds could make them even more popular.
There are times when information is true, but not accurate. This seems to be one of those times. ETFs are tax-efficient because they (mostly) follow an index. This author is comparing ETFs to actively managed mutual funds, not index mutual funds. So what he said is true. But if an ETF is compared to a mutual fund following the same index, there is little to no difference in tax-efficiency.
Some people like ETFs. Others don't. They are a little more trouble, but some people think that being able to sell an ETF during the trading day (as opposed to after hours using the day's closing value) is worth it.
My suggestion is to use mutual funds unless you have a specific reason to prefer ETFs.
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Re: Is ETF more tax-advantaged than mutual funds?
by Bracket » Sun May 18, 2014 5:59 pm
My understanding is that the real reason ETFs are more tax efficient than mutual funds is that ETFs can "give away" their appreciated shares of stock with the lowest cost basis (and thus largest gain) when "creation units" are redeemed. They therefore avoid passing on the capital gains, and resulting taxes, to you and I when this occurs. In contrast, a "regular" non-ETF mutual fund cannot give the appreciated shares away "in kind", but must sell them, realize a capital gain, and pass that gain on, along with the taxes, to you and I.
I think the article missed that whole point and vastly oversimplified the reasons for the tax efficiency of ETFs. Any low turnover index fund or ETF could be tax efficient, but it is the unique ETF structure that makes ETFs even more so.
Also, a caveat, this does not apply to vanguarrd ETFs because they are a share class of the equivalent mutual fund, and so there is I believe no difference in tax efficiency between say the vanguard s&p500 ETF and the vanguard S&P 500 mutual fund.
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Re: Is ETF more tax-advantaged than mutual funds?
by steve_14 » Sun May 18, 2014 8:03 pm
The jury is still out on how much the theoretical tax efficiency advantage of true ETFs, if any, will help investors.
For example, the Vanguard Total Stock Market Fund, inception: 4/27/92, has unrealized cap gains as per M* of 32.3%. SPY, the S&P 500 ETF, inception 1/22/93, has unrealized gains of 7%. Both fund have increased six fold from inception, so both managed to have neutralized most of their gains so far. This may not be true over the next few decades if investors draw down their positions instead of building them up, however.
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Re: Is ETF more tax-advantaged than mutual funds?
by placeholder » Mon May 19, 2014 2:22 am
As I understand it the Vanguard funds use the ETF shares to reduce capital gains distributions.
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