ETFs shine as high taxes loom on US mutual fund capital gains

This year is shaping up to be a rough tax year for many active mutual funds and could prompt some investors in taxable accounts to shift their assets to the more tax-efficient ETF structure, analysts say.

American Century, Columbia Threadneedle, Harbor Funds, Invesco, MFS, T Rowe Price and Vanguard have warned active mutual fund investors to expect year-end capital gains distributions equivalent to 20 per cent or more of the net asset value of the fund, according to a Morningstar review published this month.

Allspring Global Investments, the former fund business of Wells Fargo, estimates it will have two funds with distributions of 30 per cent or more of NAV, and six others with at least 20 per cent distributions, according to Cap Gains Valet’s data.

AB, BlackRock, Franklin Templeton, Janus Henderson and JPMorgan will also each be likely to have multiple funds distributing double-digit-percentage gains, Morningstar’s report notes. For some, those distributions will be up significantly from last year, when they posted mid-single-digit gains.

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Industry-wide, mutual funds issued $71.9bn in capital gains during the first half of 2021, more than double that of the first six months of 2020, according to the Investment Company Institute‘s most updated tally.

Meanwhile, just 9 per cent of the ETFs offered by BlackRock, Vanguard and State Street Global Advisors will distribute capital gains this year, according to CFRA research. Only 2 per cent of the 415 equity ETFs they collectively manage will do so.

Most of the ETFs passing along gains will distribute 1 per cent of NAV or less, wrote Todd Rosenbluth, CFRA’s ETF research chief, in a research note published last week.

Tax efficiency has long been one of the biggest selling points for ETFs due to the wrapper’s creation and redemption process, which includes in-kind exchanges of securities for fund shares, analysts say. In addition, index ETFs generally have lower turnover of holdings than active mutual funds.

“The overwhelming majority of ETFs will avoid the type of punch-to-the-gut taxable capital gains distributions that are in store for a large number of actively managed mutual funds this year,” said Ben Johnson, Morningstar’s head of ETF research.

“I think investors’ tax pain will continue to drive more of each incremental dollar of flows in taxable accounts towards ETFs,” Johnson added.

In some cases, investors’ move to ditch mutual funds for ETFs or other investment options was making the tax situation worse for shareholders that remain, Rosenbluth said. “Strong [market] performance coupled with redemptions is a recipe for capital gains,” he said. Such a combination forces portfolio managers to sell off securities that have appreciated to pay back shareholders or otherwise rebalance their portfolios.

US equity mutual funds bled $187bn during the first 10 months of the year, Morningstar Direct data shows. Some $106bn of that came out of domestic equity growth funds — the type of funds throwing off the most significant capital gains, Morningstar noted.

The capital gains hit from outflows can be exacerbated when previously fast-growing funds close to new investors, because there are few inflows to balance out redemptions, according to Morningstar’s capital gains review.

Meanwhile, ETFs already have smashed through last year’s sales, with $290bn going into US equity strategies year-to-date through October, compared with $129bn in all of 2020, Morningstar Direct data shows.

About $16bn of that haul has gone into active US equity ETFs. Such products could have higher turnover than index ETFs, which could make the active versions less tax efficient, analysts noted. But funds that must sell securities to make portfolio changes were unlikely to have significant gains to book because the funds were newer, and stocks therefore had less time to appreciate, CFRA’s Rosenbluth said.

High capital gains distributions could be the straw to make ETF holdouts change their mind, Rosenbluth said.

However, some mutual fund investors might be unaware of the tax differences between ETFs and mutual funds, he noted. In addition, some investors may hold active funds in tax-deferred accounts such as 401(k)s or IRAs, or be unconcerned about tax. Plus, tax-sensitive investors might be loath to sell mutual funds that have racked up strong gains — triggering a tax bill on the fund itself — just to move into an ETF, he said.

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