Do Active ETFs Deliver on Tax Efficiency? (2024)

FAQs

Are active ETFs tax-efficient? ›

ETFs can be more tax efficient compared to traditional mutual funds. Generally, holding an ETF in a taxable account will generate less tax liabilities than if you held a similarly structured mutual fund in the same account. From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same.

Active bond ETF offerings have seen significant growth over the last few years: About 200 distinct strategies launched since December 2020, including 73 in 2023 alone, more than any other prior year. Still, the market value of active bond ETFs only accounts for about 13% of the fixed-income ETF universe.

Thanks to the tax treatment of in-kind redemptions, ETFs typically record no gains at all. That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy.

Passive ETFs tend to follow buy-and-hold strategies to try to track a particular benchmark. Active ETFs utilize a portfolio manager's investment strategy to try outperform a benchmark. Passive ETFs tend to be lower-cost and more transparent than active ETFs, but do not provide any room for outperformance (alpha).

Typically, yes. ETFs are generally more tax efficient than comparable mutual funds because the “in-kind” creation and redemption feature of ETFs is designed to reduce cash transactions and capital gains distributions.

Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons: Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would.

ETFs are built to avoid the capital gains that result from turnover and redemptions. Investors buy or sell ETF shares on a stock exchange from other investors, not the fund. This avoids the need to raise cash to meet redemptions for small investors.

Since VTI and VOO are both ETFs, they have the same trading and liquidity, tax efficiency, and tax-loss harvesting rules. There are two key differences between VOO and VTI: the diversification strategy and performance.

Growth Projections: Capitalising on global demand

Global ETF AuM is expected to exceed $19.2 trillion by June 2028. This would represent a five-year CAGR of 13.5%, more than double the anticipated 5% CAGR for the AWM industry as a whole in the five years up to 2027.

What is the growth rate of active ETFs? ›

ETFs Outpace Mutual Funds as Flows Leader

In net asset terms, active ETFs have grown from $112 billion in 2019 to $509 billion in 2023—a 35% five-year compound annual growth rate. ETFs have experienced strong and steady inflows over the decade. Figure 1 shows 2021 established a highwater mark at over $900 billion.

While many ETFs are designed to passively track an index or benchmark, an actively managed ETF is a fund with a manager or team making decisions about the holdings. They generally try to outperform a market index or other benchmark. While actively managed ETFs have existed since 2008, demand for them is rising.

Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.

One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way, your gains receive long-term capital gains treatment, lowering your tax liability.

Tax loss rules

These capital losses can be used to offset capital gains (from any investments, not just ETFs) and up to $3,000 of ordinary income ($1,500 for married persons filing separately). Capital losses in excess of these limits can be carried forward and used in future years.

Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.

Advantages to actively managed ETFs include lower expense ratios than mutual funds and the participation of seasoned financial professionals. Many actively managed ETFs have higher expense ratios than passively-managed index ETFs, which puts pressure on fund managers to consistently outperform the market.

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

Since both VOO and SCHD are ETFs, they have the same characteristics when it comes to tax efficiency, tax loss harvesting, and minimum investment requirements. Overall, if you are looking for an ETF that generates high dividends, then SCHD is the better option.