Tax Efficiency: ETF vs Mutual Fund (2024)

Investment funds

One of the most popular investments for investors today is the exchange-traded fund (ETF). When an investor purchases an ETF, it holds several underlying investments. This can improve the portfolio's diversification, but it may also increase the taxable consequences of buying and selling securities to match targeted asset allocations.

Prior to the ETF, the most effective investment vehicle that attempted to do this at scale was the mutual fund. This was an investment fund in which many people would pool their money to invest in a common basket of securities. Investors who hold ETFs and mutual funds often encounter taxable events that will likely need to be reported on your tax return.

What is an ETF?

An exchange-traded fund (ETF) is a type of security that invests in a collection of underlying securities — such as stocks or bonds — and often tracks a benchmark.

Investors tend to use ETFs as a passive investing strategy, meaning they purchase an automated asset allocation, which usually aligns with an index, sector, or industry. ETFs can also invest in specific sectors and use different strategies. As a result of these various options, ETFs can also charge different expenses for asset management.

These expenses are generally comprised of management fees and operational expenses. Mutual funds also usually come with these expenses, but they also can include 12b-1 fees, or annual sales promotion fees. Generally, ETFs don't have these expenses because they trade on an exchange throughout the day, similar to a stock or bond.

What is a mutual fund?

A mutual fund is an investment fund that is group-funded by many investors, each of which contributes a bit of money toward a basket of securities. Mutual funds can also exist to enable investors to follow a passive investing style, meaning they buy shares in one asset which then has an investment manager who buys and sells the securities that make up the fund.

Some mutual funds attempt to replicate market indices, while others attempt to trade actively and beat associated benchmarks. Unlike ETFs, mutual funds often come with multiple share classes that investors can pick from, with each having a unique fee structuring. These different classes may require investors to pay various types of sales loads, expenses, and operational fees, affecting the mutual fund's basis. In particular, mutual funds often carry 12b-1 marketing or distribution fees.

These fees are a primary difference between an ETF and a mutual fund. Specifically, mutual funds charge 12b-1 fees to support the costs associated with marketing the fund through brokerage relationships — in other words, the cost of doing business and getting their fund in front of potential investors.

When looking at a mutual fund and ETF that invest in the same underlying assets (such as an index), the mutual fund expense ratio will likely be higher in most cases. However, there might be a commission when buying an ETF while a mutual fund might be able to be purchased without a commission.

Is an ETF more tax-efficient than a mutual fund?

In terms of capital gains and losses and dividends, tax law treats these the same for ETFs and mutual funds. However, one benefit of ETFs is that they often encounter fewer taxable events.

Because ETFs trade on an exchange, they transfer from one investor to another. As a result, the ETF creator does not need to redeem shares each time an investor wishes to sell or issue new shares when an investor wants to make a purchase.

For mutual funds, the share redemption can trigger a tax liability. When a mutual fund investor sells shares back to the fund sponsor, the remaining shareholders of the fund often incur a tax liability.

ETFs do not need to change their holdings to accommodate when an investor buys or sells shares. Rather, the ETF manager can create or redeem "creation units," or baskets of the underlying securities. This usually shields the remaining ETF investor from capital gains.

As mutual fund investors buy or sell shares, fund managers must constantly re-balance the fund. This constant change in the portfolio can create taxable events for shareholders.

When should you invest in an ETF vs. mutual fund?

From a tax perspective, ETFs often act as a better investment choice for investors because they frequently offer fewer taxable events than a mutual fund might. However, you may wish to invest in mutual funds in certain circ*mstances, depending on your investment objective.

ETFs tend to carry lower expense ratios than similar mutual funds, but they sometimes carry trading commissions from brokers when you buy or sell. In some instances, an index mutual fund can carry lower annual operating expenses than a comparable ETF.

Further, mutual funds might prove a better investment choice when you can only find ETFs that trade with low volume. When this occurs, you might face wide bid/ask spreads, whereas mutual funds trade at their net asset value and avoid bid-ask spreads altogether. Depending on your investment objective, you will want to factor these elements into your consideration.