Morningstar Advisor - April/May 2012 - (Page 61)

the trade is conducted in-kind, no capital gains are realized. While mutual funds can and occasionally do engage in in-kind transfers to meet big redemptions, they usually just liquidate portfolio holdings and distribute the proceeds to meet withdrawals. This is a practical constraint and not a legal obligation. Mutual funds deal with the public, so it would be impractical (and infuriating) to meet all redemptions with in-kind distributions. ETFs deal directly with institutional authorized participants (not the general public) when handling fund flows; they do not have to worry about generating and doling out cash. This does not mean an ETF can exclusively conduct in-kind trades and avoid realizing any capital gains. Whenever an ETF changes its composition (as opposed to its size), it must trade securities like any other mutual fund and realize capital gains and losses. With these facts in mind, there’s no surprise that really only two simple criteria predict how likely an ETF is to distribute capital gains. Did it change its portfolio composition frequently? This is distinct from but closely related to whether it had high turnover. An ETF can experience significant inflows and outflows, driving up its turnover, without making a single taxable trade. Passive, market-cap-weighted ETFs pass this test with flying colors. Did it have many opportunities to conduct in-kind redemptions? Strong performance and inflows can result in capital gains accumulating faster than they can be purged. Some ETFs cannot accommodate in-kind redemptions. ETFs tracking less-liquid markets, such as high-yield bonds and some emerging markets, and ones based on swaps or futures are prominent examples. The Capital Gains Distribution Test Exhibit 1 Five-Year Large-Blend Category Capital Gains: Active funds make hefty distributions, while ETFs have eliminated them. Investment Vehicle % Active Mutual Funds Passive Mutual Funds ETFs Data as of Jan. 31, 2012 1.92 0.16 0 Exhibit 2 Same Benchmark, Different Capital Gains: Neither of the biggest S&P 500 ETFs has ever distributed capital gains, while mutual funds tracking the same index distributed capital gains around 1%. Prospectus Benchmark Fund Name Ticker Category 5-Year Gain 10-Year Gain 15-Year Gain Open-End Fund Count S&P 500 TR SPDR S&P 500 iShares S&P 500 Index US OE Average SPY IVV Large Blend Large Blend Large Blend 0 0 1.08 0 0 0.75 0 NA 1.37 165 Data as of Jan. 31, 2012 varieties. However, distributions fall most dramatically going from active management to passive for equity funds. We ran the numbers for all categories, but for brevity’s sake we reproduced the results of fiveyear dollar-weighted capital gains distributions for active and passive mutual funds and for ETFs. Active funds make hefty distributions; passive mutual funds make almost none; and ETFs completely have eliminated them. (Exhibit 1) A few patterns stick out. First, passive strategies, regardless of wrapper, are far more efficient at limiting capital gains distributions, which stems largely from their low turnover and less-fickle investor base. Second, ETFs can improve upon this efficiency gain to a smaller degree. This improvement can entirely eliminate capital gains distributions in some cases. While the difference between active management and passive management explains most of the differences in tax efficiency between ETFs and mutual funds, we are still left with the task of explaining why capital gains differ among similar passive strategies, sometimes dramatically. To answer that question, we looked at ETFs and index mutual funds tracking the same benchmark. The S&P 500 trackers were the most common and oldest mutual funds. Neither of the biggest S&P 500 ETFs has ever distributed capital gains. S&P 500-tracking mutual funds, on the other hand, distributed capital gains in the ballpark of 1% of NAV annually. Similar results held for other ETF-mutual fund pairs that tracked the same indexes. (Exhibit 2) The bottom line: The biggest differences were between active and passive funds, regardless of structure. There were some differences on the margins between mutual funds and ETFs tracking the same indexes. Equity and fixed-income ETFs distributed capital gains less frequently and on a smaller dollar-weighted basis than open-end mutual funds of both the actively managed and passive MorningstarAdvisor.com 61 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Contents
Contributors
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012