Morningstar Advisor - April/May 2012 - (Page 60)

Gray Matters Untangling ETF Tax-Efficiency Myths By Paul Justice and Samuel Lee In-kind redemptions give ETFs an edge in tax efficiency, but other factors are bigger when comparing them with mutual funds. Exchange-traded funds have been promoted as being especially tax-efficient. While broadly true, some investors mistake ETFs as being uniquely tax-efficient. In order to dispel some myths, we investigate the structure and tax-efficiency record of ETFs. We find that physically replicated ETFs with in-kind creation and redemptions tend to be more tax-efficient than their open-end counterparts, but the magnitude of the benefits pale in comparison to factors like expense ratios, tracking error, index methodology, and replication methods. We also take a critical look at iShares’ claims that Vanguard’s dual share-class structure imposes additional costs on ETF-class investors. When Are ETFs Tax-Efficient? there are no flows in or out, a mutual fund and an ETF identical in every aspect (underlying structure, index, embedded cost basis, etc.) will distribute identical capital gains. ETFs don’t shield dividend and interest income. The ETF’s edge in tax efficiency comes from liberal use of in-kind redemptions. When an ETF experiences redemptions, it can hand over a basket of the fund’s underlying securities instead of cash. It can also pick which shares to hand over, ridding itself of tax lots with the greatest embedded capital gains. Because To understand the tax-efficiency argument, it is helpful to compare and contrast a typical ETF with a typical mutual fund. Neither mutual funds nor exchange-traded funds pay any taxes on interest payments, dividends, or capital gains. Instead they “pass through” distributions to their shareholders on a prorated basis, which are then taxed according to each shareholder’s tax situation. As long as 60 Morningstar Advisor April/May 2012

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

Morningstar Advisor - April/May 2012
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