a test morning paper from schweser asks which is more tax efficient of two funds . one is a ETF primarily small cap growth and another is a large cap value fund.
the mutual fund had higher div yield than the benchmark while the ETF had less than bm.
I wrote that higher dividend yield is less tax effcient.
The correct answer is that a ETF is more tax efficient than a mutual fund.
Was I wrong?
Not wrong, but dividend yield difference does not directly translate into tax efficiency, because it depends on the dividend receipient’s circumstances (e.g. whether in TDA or TEA or taxable).
ETF is more tax efficient because it will not subject the investors to capital gains and dividend taxes that a mutual fund would. A mutual fund would reinvest realized gains and dividends into the fund but the investor still has to pay taxes on them. Gains might be realized not just because the manager has a high turn over but also because of redemptions from other investors. ETF buys and sells just transfer the ownership of underlying stocks from one investor to another and don’t cause any taxable transactions to the fund itself.
yeah I think I know what you mean. ETF’s don’t have to sell securities against redemptions because they can redeem creation units back to authorized participants ( a.k.a big banks ) . So the redemptions are protected from taxable events because the exchange never records a sale of the security.
Similarly when the companies in the ETF’s declare a dividend the in-kind system ensure the manager can tweak the system to reduce distributions and adjust the NAV instead.
When rebalancing mutual funds have to do a lot of selling to get to an index position. An ETF can simply redeem in-kind to the authorised participant . So no selling and no taxes upon rebalancing
ETF more tax efficient because selling the ETF is not a taxable event, but itis taxable in mutual funds
Besides in ETF no record keeping is necessary, it trades throuout the day, and if holded long term it’s cost is lower than index mut. fund
selling ETF is taxable to the individual , maybe not taxable to the fund because of in-kind redemptions of creation units.
Hi Friends,
I think the point is when other investors sell (other than you), then it affects the MF taxes which in turn affects your NAV.
In case of an ETF this is not the case as the money is not “pooled together” and sales of other investors DO NOT affect your holding of the index. This is what makes the ETF tax efficient.
If you have time please read this - http://www.analystforum.com/article/cfa/regarding-the-tax-efficiency-of-etfs-by-joseph-curran
Cheers.
The bottom line of a question about tax efficiency is what will minimise tax now / or in the short term.
Value companies pay dividends, on which taxes are to be paid now. Growth companies typically reinvest profits, thereby deferring the tax impact until the eventual sale of the asset holding.
Thus in this case, the ETF (the growth asset) is the most tax efficient investment.
[deleted. I shall slink back to my corner and read Reading Comprehension 101 now.]