Today we’re expanding our investigation into ETF urban legends. No, it’s not true that there are spider eggs in your exchange-traded fund, but let’s look at two more urban legends that touch on taxes and trading.
ETFs are tax-free
A shared characteristic of mutual funds and ETFs is that, instead of paying taxes on gains, they distribute these capital gains directly to investors. Funds of any kind can generate capital gains when they sell a security that has appreciated in price, whether it’s shares of Apple (AAPL) or a 10-year Treasury note.
But before we continue, I need to congratulate you if your fund had a gain. That means securities in your fund have gone up in value, which is a desired outcome! To fund client redemptions, a mutual fund manager may have to sell shares of stocks, possibly at a gain.
However, ETFs are unique because institutions can exchange ETF shares for individual securities in an “in kind” transaction. In this type of swap, no shares are sold and no taxable event happens (no free lunch though: The gain is eventually recognized when the investor sells the ETF). This is one of the sources of the ETF’s tax advantages.
The other? The index tracker approach that most ETFs follow. Because index trackers, whether ETF or mutual fund, attempt to mimic the holdings of their target benchmark, they generally only sell a security from the portfolio if the security exits the target index (for instance, a stock that’s removed from the S&P 500 because it’s no longer large enough). That longer-term or lower-turnover approach is an advantage for ETFs and index funds because it generally produces fewer capital gains distributions. In contrast, a traditional active fund will sell securities more frequently because a stock may have reached a “target” price or because an investment thesis has changed, yielding more capital gains distributions.
ETFs tempt investors to trade more
Is ETFs’ convenience—that they can be bought and sold like an ordinary stock—actually a detractor of value, tempting ETF investors to trade more, resulting in transaction costs and poor results because of their market timing behavior?
A few years ago Vanguard sought to answer this question by examining the trading behaviors of Vanguard retail investors. The study encompassed 3.2 million transactions between 2007 and 2011 in four of Vanguard’s largest ETFs and their related mutual fund share classes.
The results? 62% of ETF investors in the study exhibited “buy and hold” characteristics, as shown in the table. While this was less than the 83% of mutual fund holders, the result appears contrary to the urban legend of a “temptation effect.” Additionally, the study found that some of the difference can be attributed to the fact that investors who are inclined to trade choose ETFs and not that investors who choose ETFs are induced to trade.
Hopefully, we’ve shed some light on the effects of investing in ETFs while simultaneously eating pop rocks…no one’s stomach is going to explode as a result. Although that would make a more interesting front page story, wouldn’t it?
Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
All investing is subject to risk, including the loss of the money you invest.