Morningstar - Winter 2019 - 52

Strategies

This can be a useful metric, though it isn't perfect
because it is influenced by expense ratios.
All else equal, funds with lower expense ratios
tend to have higher tax-cost ratios because
they have higher pretax returns (and taxes
on those returns). Of course, investors are still
better off after taxes with lower fees. But
this ratio is still less sensitive to fees than aftertax
returns, which can make it more useful for
comparing tax efficiency across funds.
To supplement the capital gain distribution
analysis, we calculated the average one-, three-,
five-, 10-, and 15-year tax-cost ratios (where
available), as of March, for each of the four fund
groups outlined above. Consistent with
the previous findings, passive open-end funds
had lower tax-cost ratios than their active
counterparts in most categories and time frames,
despite their lower expense ratios. Similarly,
passive ETFs had lower one-year tax-cost
ratios than active ETFs in six of 10 categories
and lower three-year ratios in five of six categories.
And, as before, both passive and active
ETFs appeared more tax-efficient than their
open-end counterparts.
Cleaner Benchmarks
While these comparisons are a good starting
point, they aren't necessarily an even
match. Most passive ETFs and open-end funds

track different indexes, while active ETFs and
open-end funds tend to pursue different strategies.
Differences in expense ratios, turnover, and
flows can further influence tax efficiency. Outflows
from active funds and inflows into passive
funds contributed to active open-end funds' lower
tax efficiency over the past 15 years.
To better isolate the impact of the ETFs' structure
on tax efficiency, we narrowed our sample
to passive ETFs and open-end funds that track
12 broad, market-cap-weighted indexes. For
example, we compared ETFs that track the S&P 500
to open-end funds that track the same
benchmark. Our sample included several S&P and
Russell domestic equity indexes, the MSCI
ACWI Ex USA Index, and the Bloomberg Barclays
US Aggregate Bond Index. Across the board,
the ETFs were more tax-efficient than their
open-end counterparts. For every index included,
ETFs made smaller capital gain distributions
relative to their NAV. They were also less likely to
make any capital gain distributions at all and
tended to have lower tax-cost ratios.
To further investigate the impact of flows on tax
efficiency, we subdivided the open-end and
ETF funds that tracked these indexes into two
groups: those with net inflows and those
with net outflows. We then recalculated the taxefficiency metrics for those groups.

Structure More Significant Than Strategy for Tax Efficiency
Differences Between Average Capital Gains Distribution/NAV (%)
Active OEPassive ETF

Active OEPassive OE

Active ETFPassive ETF

Passive OEPassive ETF

Active OEActive ETF

Large Blend

3.44

1.93

0.24

1.51

3.26

Mid Blend

4.03

0.52

-0.34

3.52

6.53

Small Blend

5.02

0.81

-

4.21

-

Foreign Large Blend

1.69

1.31

0.56

0.87

0.68

Diversified Emerging Markets

2.95

2.58

0.20

0.10

0.67

Intermediate-Term Bond

0.32

0.15

0.46

0.15

-0.11

High Yield Bond

0.34

-0.22

-0.06

0.30

0.42

52

Morningstar Winter 2019

There weren't many ETFs with outflows in this
sample, but there didn't appear to be a significant
difference between the tax efficiency of ETFs
with inflows and those that experienced outflows,
which is a stark contrast to open-end index
funds. In fact, outflows are an opportunity for
ETF managers to transfer low-cost-basis
shares out of the portfolio through the in-kind
redemption process.
Tax-Efficient, Not Tax-Exempt
Investors in ETFs will still pay taxes on regular
distributions of income, and they will be on
the hook for capital gains taxes when they sell an
ETF for more than they paid for it. Also, some
ETFs will distribute capital gains, though they tend
to be less frequent and of lesser magnitude
than those their mutual fund counterparts generate.
But ETFs are more tax-efficient, thanks mostly
to their unique structure and with some help from
their underlying strategies. Though they are
not immune to taxation, ETFs allow investors
to defer the realization of capital gains taxes. K

EXHIBIT 4

Source: Morningstar, Analyst's Calculations. Data as of 12/31/2018.

As expected, open-end funds with net outflows
tended to make larger capital gain distributions
relative to their NAV than those with net
inflows. This is because their managers have been
forced to sell securities to raise cash to meet
redemptions, often realizing taxable capital gains
in the process. That said, many open-end funds
with inflows still made capital gain distributions.
Open-end funds with outflows had higher
tax-cost ratios than those with inflows in five of 10
categories over the trailing 10 years through
March 2019. It's also worth noting that ETFs with
inflows were still more tax-efficient than indexmatched open-end funds with inflows.

Note: Further details underlying the conclusions
here are laid out in extensive tables in the original
paper, available at https://direct.morningstar.com/
research/doc/940313/magazine .
Ben Johnson, CFA, is director of global exchange-traded
fund research with Morningstar Research Services. He is a
member of the editorial board of Morningstar magazine.
Alex Bryan, CFA, is director of passive strategies, North
America, with Morningstar Research Services. He is the
editor of Morningstar ETFInvestor.
https://direct.morningstar.com/framework/login?redirectUrl=/research/doc/940313/magazine https://direct.morningstar.com/framework/login?redirectUrl=/research/doc/940313/magazine
Morningstar - Winter 2019

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