Exchange-traded funds, or ETFs, are significantly more tax-efficient investments than mutual funds. This is primarily due to the differences in structure between the two investments and the different way in which these two investment instruments are traded.

The basics of taxation for either mutual funds or ETFs is if they appreciate in value so an investor realizes a profit, a capital gain is then created and taxes are due. Some overstate the case for ETFs and talk about them as if they were tax-free. That is not the case. The government still wants a piece of all capital gains realized, either through appreciation in net asset value, or NAV, or through any dividends that may be received. Of course, capital gains are tax-deferred until retirement if an investor's mutual funds or ETFs are purchased and sold in an employer-sponsored retirement plan, such as a 401(k), or in an individual retirement account, or IRA.

However, there remains a distinct tax advantage for ETF investors revealed by a basic statistical analysis. In the period from 2000 through 2010, the average small cap-oriented mutual fund produced capital gains to shareholders equal to roughly 7% of NAV. Over the same time frame, a comparable small cap-focused ETF only paid out capital gains equal to about 0.02% of net asset value. This is a huge gap and represents a huge difference in corresponding tax liability.

ETFs and Tax Efficiency

One of the main reasons ETFs are more tax efficient is due to the fact they generally create fewer taxable events than most mutual funds. The overwhelming majority of ETFs only sell holdings when the elements that compose their underlying index change. A significantly lower portfolio turnover rate means significantly fewer taxable gain incidents. Some actively traded equity mutual funds have turnover rates higher than 100%. In contrast, the average turnover rate for an ETF is less than 10%.

In respect to this aspect of ETFs versus mutual funds, ETFs that aim to mirror the performance of specialized, nontraditional indexes or are constructed using proprietary criteria for portfolio selections, may have notably higher turnover rates. However, the turnover rate is still, in all likelihood, lower than the average for mutual funds.

A Basic Structural Difference

The primary differential in tax efficiency stems from the fundamentally different way in which ETFs are structured, or the specific type of investment asset they are as compared to mutual funds. One of the key structural differences is while ETFs are traded on exchanges, just like individual stocks, mutual fund shares are bought directly from, and sold directly to, the mutual fund company. What this means for an individual investing in a mutual fund is the choices and actions of his fellow fund investors can affect the individual's own tax liability. This is not true for ETFs. The way this happens is if other investors in the mutual fund decide to sell, or redeem, a substantial amount of shares, the odds are the fund manager is forced to sell part of the mutual fund's holdings to have sufficient cash to pay for the shares being redeemed. This selling of portfolio holdings most likely results in some level of capital gains being realized, and those gains are then passed on to fund shareholders who are liable for the taxes due on the realized gains.

ETF shares do not work that way. ETF shares are simply traded back and forth, through an exchange, between individual shareholders. Therefore, there is no need to liquidate any of the ETF's holdings to pay sellers of ETF fund shares, and, thus, no capital gains are produced. This is another way in which ETFs function, which creates fewer taxable events.

Phantom Mutual Fund Gains

Another tax disadvantage for mutual funds arises from what are referred to as "phantom gains." Phantom gains occur when an investor happens to buy mutual fund shares just prior to the fund manager making a large sell of fund holdings. In an actively managed mutual fund, the fund manager may choose to sell all of the fund's shares in a stock that has appreciated in price a great deal from the fund's original purchase price. This may happen because the fund manager wants to improve the appearance of the fund's return just prior to a reporting period or simply because the manager believes the stock has exhausted its upside potential. In any event, the sale creates capital gains and resulting tax liability for fund shareholders. For shareholders who have invested in the fund for quite some time, the gain in the NAV of their shares since buying into the fund may more than compensate for any resulting tax liability. However, newer shareholders who have only recently bought into the fund experience the unfortunate circumstance of being taxed on gains that were of little or no benefit to them.

Thus the term, phantom gains.

Again, this does not happen to investors in shares of ETFs. Because of the way ETFs work, securities in the ETF portfolio are exchanged "in-kind" for fund shares, and new fund shares are created through an in-kind exchange for securities. Thus, securities are regularly returned at a low cost basis and received at a higher cost basis. When securities are sold for rebalancing with a changing index, this translates into, officially at least, a smaller profit showing, and therefore a lower taxable capital gain amount than is the case for a mutual fund engaging in essentially the same type of transaction.

Investors should note that the ETF tax advantage, while still significant, is typically less for fixed-income ETFs, as such ETFs usually have higher turnover rates and more redemptions that create taxable events than is the case with equity-based ETFs.

Financial analysts point out ETFs have additional advantages over mutual funds as an investment vehicle beyond just tax advantages. One additional advantage is transparency. ETF holdings can be freely seen day to day, while mutual funds only disclose their holdings on a quarterly basis. Another important advantage of ETFs is greater liquidity. ETFs can be traded throughout the day, but mutual fund shares can only be bought or sold at the end of a trading day. This can have a significant impact for an investor when there is a substantial fall or rise in market prices by the end of the trading day. A final advantage is generally lower expense ratios. The average expense ratio for an ETF is less than half the average mutual fund expense ratio.