Beating Uncle Sam: How Active ETFs Deliver Superior Tax Efficiency for Investors

But active ETFs could be as good as it gets.

Thanks to several structural differences between ETFs and mutual funds, active ETFs’ tax efficiency is off the charts. This doesn’t include tax-loss harvesting prospects. For investors, this creates plenty of opportunities to generate additional tax-alpha and bigger long-term returns. For investors, this tax efficiency is just another reason why active ETFs need to be on your radar and in your portfolio.

For decades, the humble mutual fund has been the preferred vehicle investors use to build portfolios. And it’s easy to see why. Mutual funds pool investors’ capital together and use that capital to purchase various assets (e.g., stocks, bonds, real estate). By pooling all this capital, investors get instant diversification, ownership rights, and the ability to dollar-cost average their savings over the long haul. By and large, mutual funds are more efficient than trying to purchase hundreds of individual stocks or bonds.

But there is a problem with mutual funds. Uncle Sam gets to reap the benefits of mutual funds through taxes.

Due to mutual funds’ structures, investors are on the hook for whatever goes on in the fund. The pooling of the capital and rules enacted under the Investment Company Act of 1940 are to blame.

So, when shareholder money flows out of a mutual fund and the fund doesn’t hold enough cash to make the redemptions, the fund’s manager must rebalance the fund by selling securities. This is even true for index funds. For active funds, sales of assets can occur for any reason. For example, a stock hits a predetermined price point, a bond is now overvalued, a manager wants to raise cash to wait for opportunities, etc.

All of these sales are considered taxable events by the IRS. At the end of the year, a mutual fund pays out gains to its shareholders. Those capital gains can be taxed at both long and short gains rates depending on the fund’s holding period. The biggest insult to injury might be that even if you have a loss on the mutual fund investment, you may still have to pay capital gains on the sales based on what happened within the fund during the year.

This is where ETFs outshine mutual funds. ETFs tweak the Investment Company Act of 1940 and add more layers to their structure, chief of which is the creation/redemption mechanism.

Here, authorized participants (APs)—who are registered, self-clearing broker-dealers—package the underlying stocks, bonds or whatever into so-called creation units. The AP delivers these to the fund sponsor, who bundles the securities into shares of the ETF. The AP then places these shares on the secondary market. The reverse happens when a manager sells assets in the fund or an AP decides to redeem their shares. They get physical assets from the sales.

Those of us in the secondary market–i.e., buying and selling shares on the exchange–never see this process because it happens in kind. We never get hit with the capital gain effects. This helps drive ETFs’ overall tax efficiency versus mutual funds.

And it turns out active ETFs are effective at delaying and avoiding these capital gains. In fact, they are better than passive/index mutual funds when it comes to tax efficiency. A new report from BlackRock shows just how efficient active ETFs are versus their peers. Over the last five years, only 16% of active ETFs paid capital gains taxes. This compares to more than 53% of active mutual funds. Even the average passive index mutual fund still managed to pay out about 2.9% in capital gains over the last five years. ¹

This chart sums up their findings.

Source: BlackRock

The best part is that active ETFs’ tax efficiency has gotten better. American Century data shows the average active equity ETF only handed out 0.04% in capital gains last year. This year is expected to be low as well. This follows a trend that passive ETFs also had. When the fund form first took hold, capital gains did occur in passive ETFs, only to drift lower until most of them now do not as APs and structure gained scale.

Taxes are important when it comes to active management and returns. BlackRock shows that the average top quartile large cap fund has managed to beat the S&P 500 by 0.82% per year over the last five years. However, after taxes are taken into account, these funds have underperformed by a whopping 1.46%. Taxes have helped feed the narrative that active management underperforms passive indexing.

But with better tax efficiency, active ETFs are helping rewrite the story and show that active management does and can actually perform better than benchmarks.

What you keep is just as important as what you earn when it comes to investing. And in that, ETFs are simply a better structure than mutual funds. Moreover, active ETFs are helping win the war of better returns and additional tax alpha. Active ETFs can also be used in tax harvest situations as well, potentially adding more gains and returns.

Popular Active ETFs 

These ETFs are sorted by their YTD total returns, which range from -2.7% to 7.8%. They have expense ratios between 0.17% and 0.36% and have assets under management between $5B and $30B. They are currently yielding between 0.8% and 9.7%.

Ultimately, active ETFs are great tools for additional performance while still maintaining high tax efficiency. The proof is in the data. This makes them great building blocks for portfolios and allows investors to use taxable brokerage accounts more proficiently for their needs.

Taxes are a real drag when it comes to investing, especially for mutual funds. However, active ETFs are quickly winning out over their passive and active mutual fund rivals. With lower tax cost ratios and better returns, active ETFs have plenty of potential to boost portfolios’ returns and increase investors’ after-tax balances.

¹ BlackRock (April 2024). Vehicle structure, strategy and asset class impact fund tax efficiency