By Matthew J. Bartolini, Head of SPDR Americas Research.

Matthew J Bartolini, Head of SPDR Americas Research.

With more than 71% of global equities pushed into a bear market by year-end and global bonds posting negative returns, many investment strategies incurred losses in 2018. Within US equities – a large portion of many investors’ portfolios – having an active manager at the helm didn’t provide much ballast against losses: Only 39% of active US equity managers beat their benchmark last year, challenging the commonly held belief that active managers are able to outperform in down markets.

For investors, it may feel like there’s nothing worse than being hit with negative returns while paying active management fees which push returns deeper into the red. We can, however, think of one possibility that could be even worse: Experiencing a down year, paying active management fees, and then being slapped with a massive capital gain dividend at year-end.

In 2018, as in most years, the blow from capital gains was mostly felt by mutual fund holders – not ETF investors. This highlights one of the key benefits of the ETF structure: tax efficiency.

A continuing trend: Smaller proportion of ETFs than mutual funds paid capital gains in 2018

In 2018, just 6.2% of all US-listed ETFs paid a capital gain, compared to more than 60% of US mutual funds. This is not a one-off occurrence. As shown below, the proportion of ETFs that paid a capital gain hasn’t crossed the 10% mark in the last ten years. On the other hand, more than half of all mutual funds have paid out capital gains in five of the last six years, with 2018 marking a recent high of 62%.

Figure 1: ETFs vs. mutual funds: Percentage of Funds that Paid a Capital Gain

Source: SPDR ETFs.

Why it matters: Capital gains taxes chip away at take-home returns

Strategies with high management fees reduce investors’ take-home returns. Same with taxes. In other words, a lower tax bill enables investors to take home more of their returns.

Consider two strategies that follow the same benchmark: one is an ETF and the other is a mutual fund. Both charge a fee of five basis points. In a given year, both strategies generate the same return of 10%. The mutual fund, however, has a $0.83 short-term capital gain dividend – equal to the median mutual fund dividend in 2018.

The table below shows the difference in take-home returns for a starting investment of $1,000,000, assuming the midpoint of individual federal marginal income tax rates of 24%. (Short-term capital gains are taxed as income.) The hypothetical ETF would have provided a one-percentage-point higher return in this scenario. As such, ETFs have the potential to offer “tax alpha.”

Figure 2: Hypothetical example of “Tax Alpha”

Source: SPDR ETFs.

Primary drivers of the divergent capital gains profiles

What’s behind the contrast in capital gains profiles for ETFs and mutual funds? To start, most mutual funds follow active strategies (70% of mutual funds are active) while most ETFs follow index-based strategies (2% of ETFs are active). Generally speaking, index-based strategies are widely believed to be more tax efficient as they generate lower turnover. Consequently, fewer transactions are executed that could potentially result in a capital gain. On the other hand, active strategies typically have higher turnover, which means greater potential for realized capital gains due to a higher volume of trades executed.

But there is more to the story, as 30% of mutual funds are index-based and those strategies paid capital gains, too. It’s also important to consider an inherent difference in the operational structures of ETFs and mutual funds. This difference creates the potential for ETFs to provide investors with “operational alpha.”

Here’s how it works:

Mutual funds: When an investor buys mutual fund shares, cash flows into the fund which the portfolio manager then invests in various securities. In return, the fund issues shares to the investor. When an investor decides to sell the mutual fund shares, the portfolio manager sells securities to raise the cash needed to meet the redemption request.

• Key takeaway: This cash dependency leads to tax inefficiencies, particularly when a mutual fund must meet large and/or unexpected redemptions. If the mutual fund sells underlying securities that have increased substantially in price, that capital gain is passed on to the investor.

ETFs: The creation and redemption process for ETFs takes place in the primary market and is facilitated by authorized participants (APs). APs are US-registered, self-clearing broker-dealers who regulate the supply of ETF shares in the secondary market. APs buy the securities that an ETF holds and then transfer them to the ETF sponsor in return for shares of the actual ETF. Once the ETF shares are transferred to the AP, they can sell the ETF shares to investors on the secondary market. This is how ETF shares are created. The process also works in reverse: If an AP buys enough shares of the ETF, they can transfer the ETF shares to the sponsor in return for the underlying securities held in the ETF.

• Key takeaway: The creation/redemption process is centered on in-kind securities transfers between the AP and the ETF sponsor, as shown below. In most cases, no cash is required to facilitate this transaction. In effect, this limits transactions within the ETF itself by the portfolio manager, drastically reducing the possibility of realizing a capital gain. This critical difference in fund structure makes ETFs a more tax-efficient vehicle for investors with non-qualified assets to manage.

Figure 3: How ETFs are created and redeemed

Source: SPDR ETFs.

How investors can respond: Consider replacing mutual fund strategies with ultra-low-cost ETF strategies

When evaluating their active mutual fund managers in 2018, investors were faced with the unappetizing combination of tax impacts, dour market performance, and the high likelihood of below-benchmark returns. Given this scenario, it’s no wonder ETF inflows surpassed $300 billion in 2018 – the second consecutive year of inflows greater than $300 billion.

Tax- and fee-conscious investors who are unhappy with their current mutual fund strategy can consider rotating into an ultra-low-cost ETF strategy that provides similar market exposure, but with the added potential benefit of lower costs and the probability of improved tax efficiency.

SPDR Portfolio ETFs offer access to 15 portfolio building blocks designed to provide broad, diversified exposure to core asset classes at an average expense ratio of just six basis points. This suite of ETFs may be the right fit for investors looking to harness the operational and tax alpha inherent in the ETF structure.

This post was written with contributions from Charles Champagne and Martin Dunn. Charles Champagne is the Head of Portfolio Insights and Research Analytics, and Martin Dunn is a Research Analyst in the SPDR Americas Research Team.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)