Are ETFs More Tax Efficient? No.

Bringing after-tax returns out of the shadows is nothing new for The Independent Vanguard Adviser—I’ve been doing it for years. Thanks to some work I’ve been doing over the past months, I now have an enhanced way to track and calculate after-tax returns, giving me the ability to dive deeper into the topic than before. For instance:

• In Taxing Returns, I defined some key terms and provided a snapshot of Vanguard funds’ after-tax returns.
• In Avoiding Tax Bombs, I dispelled the myth that low-turnover funds are more tax efficient while giving you better tools to identify funds that may saddle you with a large capital gains distribution.

I’ve been building towards discussing the “big” question of whether active funds can possibly beat low-cost index funds after taxes, but before I go there, we need to untangle the mutual fund versus exchanged-traded fund (ETF) web—otherwise, every time I mention index funds, someone will ask, “But what about ETFs?”

This is an easy web to untangle, though—at least at Vanguard. The bottom line is that, at Vanguard, the index funds and their ETF siblings deliver the same after-tax returns.

This runs counter to the industry’s standard mantra that ETFs are more tax-friendly than mutual funds. So, I’ll explain why this is so at Vanguard and show you the proof in the performance pudding—plus, for those that want, I get into the nitty-gritty of why ETFs are typically considered more tax efficient than mutual funds.

Let’s start at the beginning by defining what an ETF is and how it is different from a mutual fund.

What are ETFs?

Mutual funds trace their origins back to the 1920s. They are investment vehicles that allow individual investors to pool their money together so a professional can then invest those dollars for them—that portfolio manager may actively pick the stocks (or bonds) for the pool in an effort to “beat the market,” or they might simply try to track an index.

The idea is that if you have, say, just $10,000 to invest, it is hard to build a diversified portfolio on your own. You’ll also be hard pressed to find a professional investor willing to oversee an account that size. But if you can pool your money with others like you, well, that solves those problems.

I’m a big fan of mutual funds—as you might expect from someone writing a newsletter focused on one of the largest mutual fund companies in the world. I’ll be the first to admit that mutual funds and the industry around them are not perfect, but on the whole they have made diversified investing (and hence the opportunity to build wealth by spending time in the market) accessible to a wide range of potential investors.

Exchange-traded funds (ETFs) are mutual funds that you can trade throughout the day like a stock—think of them as mutual funds version 2.0. ETFs, which were born in the 1990s and improve upon some of the flaws of the mutual fund structure, have been growing in popularity over the years, particularly as indexing has become the default setting for many investors.

Most ETFs aim to track a standard index—think the S&P 500 index or NASDAQ Composite—but there are thousands of ETFs available today. An ETF outside of standard indexed fare might aim to provide exposure to niche parts of the market, use leverage, or be actively managed. At Vanguard, aside from its five factor ETFs and one bond ETF, you’ll mainly find ETFs tracking mainstream, plain vanilla indexes.

The chief difference between mutual funds and ETFs is that ETFs trade throughout the day, like stocks. This means the price you receive depends on when you hit the buy (or sell) button. Mutual funds, on the other hand, only trade once, at the end of each day. Everyone who buys or sells a mutual fund on the same day receives the same price.

ETFs and mutual funds differ in a few other, more nuanced, ways. But the ability to trade them during the day versus once a day is the key distinction for most investors—and that’s doubly true at Vanguard.

One and the Same … at Vanguard

It should come as no surprise that in developing version 2.0, the Wall Street wiz-kids found a way to make ETFs more tax-friendly than their mutual fund predecessors. Vanguard went one step further and found a way to bring the tax advantages of ETFs to mutual funds—leveling the playing field (at least in Malvern).

I know this runs counter to the standard commentary on ETFs, so let me be crystal clear: Vanguard’s ETFs have no tax advantage over Vanguard’s index funds.