Tax Impacts of ETFs

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In theory, exchange traded funds (ETFs) are supposed to reduce the tax liabilities of their holders through a mechanism which reduces the unrealized capital gains held by their shares. This is explained in ETF Tax Efficiency. Here, we will show some historical data highlighting the actual reduction in tax liability that ETFs have created in comparison to a comparable index fund.

The table below lists the average annual tax loss by index funds run by Vanguard versus a comparable ETF (mostly iShares products). The tax loss is equal to the average annual return minus the average annual post-tax return (pre-liquidation). Thus, it represents the losses from taxes paid on interest, dividends and realized capital gains. The Difference columns represents the index fund’s tax loss minus the ETF’s tax loss.

Table 1: Average Annual Tax Loss by Asset Class – Last 3 Years (ending 9-30-06)
Asset Class Index Fund ETF Difference
S&P 500 0.3% 0.7% -0.4%
S&P Value 0.4% 0.5% -0.1%
S&P Small Cap 0.2% 0.2% 0.0%
S&P Small Cap Value 0.5% 0.3% 0.2%
MSCI EAFE 0.5% 0.4% 0.1%
MSCI Emerging Markets 0.3% 0.1% 0.2%
REIT 2.0% 1.5% 0.5%
Treasury – intermediate term 1.7% 1.4% 0.3%
TIPS 1.7% 1.4% 0.3%

We see that there does seem to be a reasonable reduction in the tax loss in several of the asset classes. This makes sense since Treasuries and Emerging Markets have high turnover and capital gains are often realized. It is surprising that the ETF for the S&P 500 actually has a higher tax burden. This might be due to a difference in the tax calculations. Note that all these tax calculations occur after Bush’s tax cuts reduced taxes on long term capital gains and dividends.

Now, let’s look over a longer time horizon. We will compare the index funds and ETFs from the time of their inceptions.

Table 2: Average Annual Tax Loss by Asset Class – Since Fund Inception (ending 9-30-06)
Asset Class Index Fund ETF Difference
S&P 500 0.5% 0.6% -0.1%
S&P Value 1.5% 0.5% 1.0%
S&P Small Cap 1.5% 0.3% 1.2%
S&P Small Cap Value 1.3% 0.3% 1.0%
MSCI EAFE 0.6% 0.4% 0.2%
MSCI Emerging Markets 0.6% 0.1% 0.5%
REIT 2.2% 2.0% 0.2%
Treasury – intermediate term 2.4% 1.4% 1.0%
TIPS 2.4% 1.4% 1.0%

Here we see significant tax savings from the ETFs in many asset classes. Many of the ETF’s had inception dates in 2000 or later. Now, we are looking at periods which include the pre-Bush tax cut years. So, the tax burden on realized long term capital gains was higher.

The ETFs included in this analysis are: Spiders (SPY), iShares S&P 500 Value, iShares S&P 600, iShares S&P 600 Value, iShares EAFE, iShares MSCI emerging markets, iShares Dow Jones REIT, iShares Lehman 7-10 yr. Treasuries, and iShares TIPS. Note: The S&P 500 comparison from inception is actually just for the last 10 years since Vanguard doesn’t have post-tax data from the inception.