"Of life's two certainties, there is only one for which you can file an extension"

In 1924, mutual funds were a groundbreaking innovation, allowing investors to diversify their portfolios efficiently across numerous companies. Today, after nearly a century of evolution, mutual funds manage over $22 trillion in assets. However, despite their ongoing improvements and cost reductions, many mutual funds still suffer from a significant tax inefficiency. In this blog post, we'll explore how mutual funds can increase your tax bill and why Exchange Traded Funds (ETFs) might offer a more tax-efficient solution.

The Tax Problem with Mutual Funds

When your mutual fund sells securities in its underlying portfolio during the year that results in net realized gains, it must pay those out to shareholders via distributions.

Even if you did not personally sell any shares of your mutual fund during the year, you may still have a gain reported on your 1099. This creates a taxable event and can drag on your returns.

For someone with only tax-deferred/tax-free retirement accounts, this isn’t an issue. For the taxable investor, it is quite important.

Illustrating the Issue - American Funds vs. Vanguard

We’re going to pick on American Funds for this example. Nothing against them, but some of the largest actively managed mutual funds are run by American Funds (thanks to the salesforce of the big green machine headquartered in St. Louis).

Below we highlight the American Funds Growth Fund of America (GFAFX), pulling data from Schwab’s mutual fund research tool. These figures are based on the highest federal income tax bracket.

Everything looks great on a pre-tax basis, earning 12.57% annualized over the last 10 years. Unfortunately for an investor in the highest tax bracket, even if they had never sold a share during those 10 years, they would have lost 1.67% of that return annually to the tax collectors.

This fund has paid out capital gains every single year since 2013. Yes, that even means in 2022 when it declined nearly 31% in value that taxable investors had to realize capital gains. Ouch! Other than that, how was the play Mrs. Lincoln?

The Growth Fund of America uses a benchmark of the S&P 500 Index. Let’s go ahead and see how a fund that tracks the S&P 500 index would compare, using the Vanguard 500 Index Fund (VFIAX):

A few items quickly stand out when comparing these results to the Growth Fund of America. For one, the benchmark had better returns over the 3,5, and 10 year periods. This is unsurprising as 93.14% of actively managed US equity mutual funds failed to beat their benchmarks over the past 10 years (before accounting for taxes). Two, the tax cost ratio is significantly less using the Vanguard 500 Index thanks to its low turnover approach.

Another point worth mentioning is that the expense ratio (how much the fund company charges to manage the fund) on the Vanguard 500 index is only 0.04% per year compared to 0.67% for the Growth Fund of America.

Actively managed mutual funds have the odds stacked against them, as they generally charge higher fees and will expose investors to higher taxes. This results in a few big hurdles to overcome for the fund’s managers. As an investor trying to place the odds best in your favor, these are good reasons to avoid actively managed mutual funds.

ETFs: A Tax-Efficient Alternative

While mutual funds have the common problem of being forced to pay out capital gain distributions, a unique feature of exchange traded funds largely avoids that problem.

When someone requests to sell their mutual fund, the manager must sell securities to generate cash which may result in the previous mentioned realized capital gains.

ETFs accommodate purchases and sales through an in-kind share creation and redemption process, which enables them to shed securities that may generate capital gains.

American Century shows below that very few ETFs spin off capital gain distributions compared to mutual funds, and also shows us that the Growth Fund of America mentioned above is not so much an exception but very much the norm with active mutual funds.

Vanguard launched at ETF for its 500 index in 2010 (VOO), and it has never paid out a capital gain distribution to date.

Conclusion

While mutual funds have been instrumental in shaping the investment landscape for a century, their tax inefficiencies can impact investors' overall returns. ETFs, on the other hand, offer a tax-efficient solution, making them a worthy consideration for investors looking to optimize their tax bills. When selecting investments, it's crucial to understand the tax implications and consider ETFs as a viable alternative to traditional mutual funds.