If it were up to me, chocolate would be considered one of the major food groups, with truffles a particularly important staple dish. Fortunately, they are also a good metaphor for explaining the tax treatment of ETFs and mutual funds. Just as a good truffle has two layers of sustenance, mutual funds and ETFs share two layers of taxation.
First, the truffles.
Candy connoisseurs have control over the first layer of sustenance. They can choose whether or not to eat a truffle based on its visible outer shell flavor (in my case, preferably dark chocolate). There’s less control over the second layer. The truffle maker decides what’s inside, and in the absence of labeling, truffle eaters don’t know the flavor until they take a bite. If some amount of labeling exists, there’s relatively more control over the second layer. Dessert seekers might know what’s inside the truffle so they can decide whether or not to eat it.
Now the first tax layer for investors
Investors effectively choose whether or not to trigger capital gains or losses by selling their shares of an ETF or mutual fund. What’s the difference in taxation between ETFs and mutual funds? Nothing. Capital gains or losses on the sale of ETF and mutual fund shares by investors are subject to the same capital gains taxation rules.
The second layer mystery
It’s also the case that investors have less control over the second layer. Portfolio managers of both mutual funds and ETFs buy and sell a fund’s portfolio securities, and the exact amount of any resulting capital gains distributions is unknown until later. Despite what you might have heard about index funds and ETFs, it’s possible for each to pay capital gains distributions. However, each has the same impact on investors. Capital gains distributions by ETFs and mutual funds are subject to the same taxation rules.
But what if some labeling—such as whether a fund follows an index or active strategy—exists?
Even if investors see the label, they still can’t prevent capital gains distributions. However, they can influence the relative amount to which they might be exposed.
This is because index funds typically have lower portfolio turnover than active funds (see charts below) and therefore typically distribute fewer capital gains than do active funds. As I highlighted in my conversation with my dad about ETFs, the more relevant label is whether or not the fund follows an indexing or active strategy, rather than whether it is an ETF or mutual fund.
If you’re more knowledgeable about ETFs, please note that the figures in the charts do take into account the effects of the in-kind creation/redemption mechanism largely used to issue and redeem shares.
The use of in-kind creations and redemptions can enhance the tax efficiency of ETFs. However, the majority of tax efficiency benefits are due to the indexing strategy, as indexing is inherently very tax-efficient. In addition, mutual funds also have the ability to use in-kind creations and redemptions.
Source: Vanguard calculations using data from Morningstar Direct. Includes all US domiciled mutual funds and ETFs in the “Equity,” “Fixed Income,” and “Tax Preferred” global broad category groups as defined by Morningstar. Excludes funds for which a turnover ratio can not be calculated or has not been reported. Charts depict weighted average portfolio turnover as reported in the funds’ most recent annual report as of March 31, 2015.
One final thought relates to the tax treatment of fund dividends, which, like nuts placed inside or outside of a truffle, might not necessarily be considered a layer. Simply stated, dividends realized by the portfolio must be distributed, and dividend distributions by ETFs and mutual funds are subject to the same taxation rules.
The “asset location” box
Of course, when using ETFs or mutual funds, investors could do more to reduce their taxes by practicing asset location, and dessert seekers could increase their truffle enjoyment by picking those “located” in the right box. Aside from that, capital gains, capital gains distributions, and dividends related to ETFs are subject to the same tax rules as those for mutual funds.
 In this blog, I refer specifically to those ETFs (96% of ETF industry assets) that, like mutual funds, are legally organized as “investment companies.”