Is ETF more tax-efficient than mutual fund?

Its a widely accepted fact that ETFs are more tax-efficient than mutual funds. This also is one of the salient features of ETFs and used for selling ETFs. In fact, this is true and to understand why this is so, we need to look under the hood, as to how ETFs and mutual funds function.

When you buy an ETF, you bear the cost of execution, both when you enter the fund and when you exit the fund. In the case of mutual funds, when you take a position, the cost of execution of that transaction is spread among all the fund holders. To better understand this, let us walk through the entire process of buying and selling in both cases.

In the case of mutual funds, when you buy units of the mutual fund, the fund manager purchases the underlying assets. All the cost involved in buying and selling of the underlying assets is borne by all the unitholders as your transaction is being executed at NAV. Similarly, in case you sell your position or redeem your MF units, part of the entire MF portfolio needs to be sold since trading is done within the fund, the cost of the transaction such as brokerage or commission need to be distributed among all the investors in the fund. Therefore, even if you remain invested, NAV of a mutual fund is subject to expense related to other investors coming into and out of the fund.

In case of ETF transaction, it is different. When you purchase an ETF, its like buying shares in a secondary market, which leads to a creation of new units of ETF. That creation involves the broker purchasing the basket of underlying assets and delivering them to the ETF issuer. When it comes to the selling of ETFs, the issuer delivers a portion of the underlying assets of the fund. The ETF issuer is not trading the assets in the markets so any gains that would have been generated from a purchase and sale are not occurring in the fund. This leads to generally lower distributions of capital gains in equity index-based ETFs.

Additionally, any activity by investors is happening in the shares on the secondary market, outside the ETF, and only those investors are bearing the costs of those transactions. Moreover, any activity by you impacts only you as all the activities by investors is happening outside the fund and you will be bearing any cost involved in such transactions. The action of the other investors does not impact your position much in case of ETFs like they would have been in a mutual fund.

Creating and extinguishing shares of the ETF can be done on an exchange, just like an individual stock, without creating a turnover in the underlying portfolio. If there is no turnover in the underlying securities, a taxable event cannot occur. In contrast, mutual fund shares are always bought and sold directly to and from the mutual fund company, and they are not exchange listed.

The ETFs are definitely better placed in terms of tax-efficiency and hence expense ratio compared to the mutual fund because of the way they are structured. Nevertheless, before going in for ETFs, there are other factors that also matter, such as management of the fund, tracking error of the fund, if ETFs suit your financial planning. You should opt for ETFs only if it is going to help you attain your financial goals.