ETFs are usually more tax-efficient than mutual funds. While both are subject to the same capital gains and dividend tax, ETFs have fewer taxable events due to their underlying structure. As a result, investors have an apparent reason to prefer ETFs over mutual funds.
Mutual funds must constantly rebalance to maintain asset allocations or accommodate redemptions. And the sale of securities creates a capital gain for all shareholders. As a result, you could have an unrealized loss on your mutual fund shares and still owe capital gains tax!
On the other hand, ETFs manage inflows and outflows by creating and redeeming creation units – or baskets of assets that approximate investment exposure. That means shareholders don’t typically experience capital gains on any individual security in the underlying structure.
But why would fund managers take a haircut on fees and convert their top actively-managed mutual funds to ETFs?
Mutual fund-to-ETF conversions enable asset managers to maintain their performance track record and retain existing shareholders through the conversion. In addition, ETFs are cheaper to run and easier to sell than mutual funds, potentially translating to a larger asset base.
Finally, new ETF rules permit mutual funds to launch semi-transparent ETFs and active non-transparent ETFs. As a result, asset managers concerned about disclosing their holdings in real time can protect their strategies and still compete in the ETF universe.