ETF Tax Efficiency: A Structural Advantage Over Mutual Funds
Taxes remain the most significant yet often overlooked variable cost for investors, with after-tax returns serving as the ultimate measure of investment success. Exchange-Traded Funds (ETFs) hold a distinct structural advantage over traditional mutual funds, particularly in taxable brokerage accounts. This edge stems from their unique redemption mechanism, where large institutional investors can exchange ETF shares for a basket of underlying securities rather than triggering cash sales.
Fund managers strategically offload the lowest-cost basis, highly appreciated securities during these redemptions. This process effectively removes unrealized capital gains from the fund without creating taxable events for remaining shareholders. The data underscores this efficiency: in 2022, active ETFs distributed just 1.81% of their Net Asset Value in capital gains—a fraction of what mutual funds typically generate.
