Is an actively managed ETF just as tax efficient as an index ETF?

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Booogle
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Is an actively managed ETF just as tax efficient as an index ETF?

Post by Booogle »

Is an actively managed ETF just as tax efficient as an index ETF?
RubyTuesday
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by RubyTuesday »

Booogle wrote: Fri Dec 03, 2021 5:31 am Is an actively managed ETF just as tax efficient as an index ETF?
Unlikely in general, but I would certainly expect there are some active funds that are more tax efficient than some index funds.

Unlikely in general because (most) index funds will trade much less frequently, especially if they track a cap-weighted index.
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Booglie
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by Booglie »

Tax-wise, it makes no difference to the investor if the fund is actively or passively managed. Any fees will be deducted from the NAV, before they reach you. However, taxes of actively managed funds are usually slightly higher.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by Booogle »

RubyTuesday wrote: Fri Dec 03, 2021 5:41 am
Booogle wrote: Fri Dec 03, 2021 5:31 am Is an actively managed ETF just as tax efficient as an index ETF?
Unlikely in general, but I would certainly expect there are some active funds that are more tax efficient than some index funds.

Unlikely in general because (most) index funds will trade much less frequently, especially if they track a cap-weighted index.

Thats what I thought.

Yet people are buying AVUV in their taxable accounts.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by RubyTuesday »

Booogle wrote: Fri Dec 03, 2021 5:43 am
RubyTuesday wrote: Fri Dec 03, 2021 5:41 am
Booogle wrote: Fri Dec 03, 2021 5:31 am Is an actively managed ETF just as tax efficient as an index ETF?
Unlikely in general, but I would certainly expect there are some active funds that are more tax efficient than some index funds.

Unlikely in general because (most) index funds will trade much less frequently, especially if they track a cap-weighted index.

Thats what I thought.

Yet people are buying AVUV in their taxable accounts.
I suspect people investing in AVUV in taxable aren’t letting the (tax) tail wag the (active factor strategy) dog
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dukeblue219
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by dukeblue219 »

Booogle wrote: Fri Dec 03, 2021 5:43 am Yet people are buying AVUV in their taxable accounts.
There are other considerations than minimizing taxes. If you believe AVUV offers upside and you might want access to it before 59.5, it makes perfect sense to hold in taxable.
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markjk
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by markjk »

Jumping on the answer bandwagon here ... if more capital gains are generated by the active ETF (which is likely), then the ETF would be less tax efficient. I suspect that is the case the majority of the time.

I'll also second that tax efficiency as a general goal is good but there are times when you might give up some of that efficiency to achieve other goals. For example, if you want access to some portion of your money at any time but still want some growth, an actively managed fund in your non-retirement brokerage account might be appropriate. That's generally frowned upon for long term money (for good reason) but if you want access to some of your money prior to 59 1/2, it might be right for you.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by exodusNH »

Booglie wrote: Fri Dec 03, 2021 5:42 am Tax-wise, it makes no difference to the investor if the fund is actively or passively managed. Any fees will be deducted from the NAV, before they reach you. However, taxes of actively managed funds are usually slightly higher.
Taxes and fees are completely separate issues.

If an active fund has more churn (changes the holdings) more frequently than an index fund, it will generate more taxable events.

This is reflected in the annual turnover rate.

If the active fund is large enough, maybe they're able to flush out some of those gains in creation unit redemptions, but I wouldn't want to rely on that.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by sycamore »

Q: "Is an actively managed ETF just as tax efficient as an index ETF?"
A: Yes, it most likely can be and is just as tax efficient but I'm sure you can find exceptions.

So far AVUV hasn't distributed any capital gains, just dividends.

Another example is the Vanguard factor ETFs - they have not made any capital gains distributions.

That's the case with most ETFs -- they pay out dividends but are able to minimize or reduce capital gains distributions. That's a feature of ETFs in general, not of index ETFs specifically.

Besides minimizing/avoiding capital gains distributions, another factor in tax efficiency is the degree to which dividends are qualified. I don't think a general statement can be made about actively managed ETFs being more, less, or equally tax efficient in this regard, because it depends on (1) the nature of the dividend paid by the underlying company (e.g., REIT, MLP, etc.) and (2) the holding period by the fund of the underling stocks that paid dividends. In this regard, small cap value stock funds are generally less than broad total market cap funds. Again, nothing particularly due an SCV fund being actively or passively managed; rather it's due to their underlying stock dividends being qualified or not.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by Booglie »

What I understand as "tax-efficient" is that any tax issues are solved by the fund manager. In other words, you don't need to pay yourself extra taxes or give extra explanations to the IRS. And also, that taxes from the manager's side will be as low as possible. An active fund can be tax inefficient and still be very profitable, or it can be tax efficient and a complete disaster.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by stan1 »

Booogle wrote: Fri Dec 03, 2021 5:43 am
RubyTuesday wrote: Fri Dec 03, 2021 5:41 am
Booogle wrote: Fri Dec 03, 2021 5:31 am Is an actively managed ETF just as tax efficient as an index ETF?
Unlikely in general, but I would certainly expect there are some active funds that are more tax efficient than some index funds.

Unlikely in general because (most) index funds will trade much less frequently, especially if they track a cap-weighted index.

Thats what I thought.

Yet people are buying AVUV in their taxable accounts.
First, since you are specifically referencing AVUV it is rules based not active stock picking, so it has a high number of holdings (674) and does not trade as frequently as an active fund would. Vanguard Small Cap Value Index holds 987 stocks. There are degrees of active and lumping Avantis or DFA or other rules based factor funds in with stock picking is not correct.

For capital gains distributions so long as the tax laws support the current ETF creation/redemption structure and heartbeat trades I expect AVUV to have none most years. Maybe small capital gain distribution occasionally. The fact is the IRS gives a tax preference to ETFs that they do not give to mutual funds.

Dividends are another matter. I don't think Avantis is using an explicit screen to remove high dividend yielding stocks for tax management, and value stocks often do pay dividends. AVUV did pay 100% QDI in 2020 though.

So, for someone who wants to overweight small cap value, right now I'm fine with holding AVUV in taxable or retirement accounts.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by sycamore »

Booglie wrote: Fri Dec 03, 2021 8:57 am What I understand as "tax-efficient" is that any tax issues are solved by the fund manager. In other words, you don't need to pay yourself extra taxes or give extra explanations to the IRS.
I don't follow. What does "pay yourself extra taxes" mean?

And with most run-of-the-mill ETFs (from Vanguard, iShares, Avantis, etc.) your brokerage will send you a 1099 form indicating the distribution types & amounts. You enter that info into tax software and submit your tax return to the IRS; no need to give any extra explanation. Are you referring to something else?
Booglie wrote: Fri Dec 03, 2021 8:57 am And also, that taxes from the manager's side will be as low as possible.
I don't know all the accounting rules of ETFs and mutual funds, but I believe the fund manager doesn't pay taxes -- dividends and any capital gains are distributed to shareholders, and it's the shareholders who bear the burden of paying taxes. Maybe you could explain "taxes from the manager's side" ?
Booglie wrote: Fri Dec 03, 2021 8:57 am An active fund can be tax inefficient and still be very profitable, or it can be tax efficient and a complete disaster.
Agree. That's true. Note that an actively managed ETFs can still be tax efficient where a similarly managed mutual fund would not be tax efficient due to the feature of ETFs as described in https://www.bogleheads.org/wiki/Exchang ... fund#Taxes.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by burritoLover »

Keep in mind that the ETF's ability to reduce or eliminate reported capital gains in not a given in the future. Congress could make that go away at any time. Which means if in taxable, you may want a passive indexed ETF anyway that has low turnover.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by Booogle »

burritoLover wrote: Fri Dec 03, 2021 9:41 am Keep in mind that the ETF's ability to reduce or eliminate reported capital gains in not a given in the future. Congress could make that go away at any time. Which means if in taxable, you may want a passive indexed ETF anyway that has low turnover.
Lol, this would screw over everyone.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by alex_686 »

RubyTuesday wrote: Fri Dec 03, 2021 5:41 am
Booogle wrote: Fri Dec 03, 2021 5:31 am Is an actively managed ETF just as tax efficient as an index ETF?
Unlikely in general, but I would certainly expect there are some active funds that are more tax efficient than some index funds.

Unlikely in general because (most) index funds will trade much less frequently, especially if they track a cap-weighted index.
I am not following. ETFs generally don't trade - active or passive. They generally exchange shares of the ETF for a basket of securities. And while this is functionally the same as trading from a tax perspective it is not. As such, not a taxable event. ETFs can "trade" all day long and not create any taxable events.

OP: Generally speaking active ETFs are very tax efficient. It depends on exactly what assets they are holding.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by burritoLover »

Booogle wrote: Fri Dec 03, 2021 9:43 am
burritoLover wrote: Fri Dec 03, 2021 9:41 am Keep in mind that the ETF's ability to reduce or eliminate reported capital gains in not a given in the future. Congress could make that go away at any time. Which means if in taxable, you may want a passive indexed ETF anyway that has low turnover.
Lol, this would screw over everyone.
Well, ETFs will just be like mutual funds I guess, as far as tax efficiency? I don't think it would be world-ending. But, certainly, many will pay more taxes - which, really, I wouldn't bet on the opposite occurring...ever.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by Booglie »

sycamore wrote: Fri Dec 03, 2021 9:32 am
Booglie wrote: Fri Dec 03, 2021 8:57 am What I understand as "tax-efficient" is that any tax issues are solved by the fund manager. In other words, you don't need to pay yourself extra taxes or give extra explanations to the IRS.
I don't follow. What does "pay yourself extra taxes" mean?

And with most run-of-the-mill ETFs (from Vanguard, iShares, Avantis, etc.) your brokerage will send you a 1099 form indicating the distribution types & amounts. You enter that info into tax software and submit your tax return to the IRS; no need to give any extra explanation. Are you referring to something else?
That's how it goes in the US, but in different countries, you may pay extra taxes to that country's IRS depending on your investment type. I'm not American, so the rules where I live are different. A tax inefficient fund, in my view, would have extra taxes (e.g, custody taxes, or paying more taxes to the IRS).
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by alex_686 »

Booglie wrote: Fri Dec 03, 2021 10:47 am That's how it goes in the US, but in different countries, you may pay extra taxes to that country's IRS depending on your investment type. I'm not American, so the rules where I live are different. A tax inefficient fund, in my view, would have extra taxes (e.g, custody taxes, or paying more taxes to the IRS).
Under the US tax code, funds need to pay dividends each year that reflect their income. If the fund earned capital gains that year then the fund needs to pay out a capital gains distribution that year. The idea is that it does not matter if you held the security directly or indirectly via a fund - taxes should be equivalent.

Due to a quirk in the US tax code ETF are able to side-step this. Instead of receiving a capital gains distribution, and paying taxes on it each year, you pay the capital gains when you sell the fund. This allows a couple of extra years of compounded growth on deferred taxes. Hence the tax drag is a bit less.

I think UK funds have a similar aspect. I am sure each country has their own quirks.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by retiringwhen »

burritoLover wrote: Fri Dec 03, 2021 9:45 am Well, ETFs will just be like mutual funds I guess, as far as tax efficiency? I don't think it would be world-ending. But, certainly, many will pay more taxes - which, really, I wouldn't bet on the opposite occurring...ever.
The relevant law applies to both Mutual Funds and ETFs. It is just that the core structure of an ETF, trading creation/redemption units with Authorized Participants makes the cost basis optimization process very efficient and effective for fund managers who take the time and effort to use the feature of the law.

Mutual Funds can do the same thing, and in fact, if I understood Gerry O'Reilly right in a recent Bogleheads podcast, Vanguard can sometimes execute a similar trade when an institution (say a 401K plan) decides to leave Vanguard for Fidelity via an in-kind redemption.
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by alex_686 »

retiringwhen wrote: Fri Dec 03, 2021 11:36 am Mutual Funds can do the same thing, and in fact, if I understood Gerry O'Reilly right in a recent Bogleheads podcast, Vanguard can sometimes execute a similar trade when an institution (say a 401K plan) decides to leave Vanguard for Fidelity via an in-kind redemption.
Back when I was in mutual fund accounting this was rare and is becoming rarer.

The fund has to be careful when making such a trade. They have to treat all shareholders equally. So they can't offer a slightly discounted trade to off-load a position with a low-cost basis. While it might benefit the shareholders with taxable accounts it would harm those in tax advantaged account. So it has to be more or less at market price.

A 401k plan would have no real incentive to do this. After all they are tax free. You need to find a taxable institution who would do this trade. i.e., a institution that would put in the trade at 1 pm (when mutual fund trades must be put in) with a price to be determined at the market close. So that 2 hours where the market could move against you. In the good old days it might be worth it for a information trader wanting to buy a big block this way without the market front-running him. Today there are generally better options.
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retiringwhen
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Re: Is an actively managed ETF just as tax efficient as an index ETF?

Post by retiringwhen »

alex_686 wrote: Fri Dec 03, 2021 11:56 am
retiringwhen wrote: Fri Dec 03, 2021 11:36 am Mutual Funds can do the same thing, and in fact, if I understood Gerry O'Reilly right in a recent Bogleheads podcast, Vanguard can sometimes execute a similar trade when an institution (say a 401K plan) decides to leave Vanguard for Fidelity via an in-kind redemption.
Back when I was in mutual fund accounting this was rare and is becoming rarer.

The fund has to be careful when making such a trade. They have to treat all shareholders equally. So they can't offer a slightly discounted trade to off-load a position with a low-cost basis. While it might benefit the shareholders with taxable accounts it would harm those in tax advantaged account. So it has to be more or less at market price.

A 401k plan would have no real incentive to do this. After all they are tax free. You need to find a taxable institution who would do this trade. i.e., a institution that would put in the trade at 1 pm (when mutual fund trades must be put in) with a price to be determined at the market close. So that 2 hours where the market could move against you. In the good old days it might be worth it for a information trader wanting to buy a big block this way without the market front-running him. Today there are generally better options.
The podcast specifically mentioned an in-kind redemption for the purposes of changing fund manager (e.g., moving a 401K plan Vanguard S&P500 fund to a Fidelity Large Cap fund) where an in-kind redemption could be a reasonably efficient for both parties. I agree not very often, but within the law. I think Total Stock Market and S&P 500 funds are a likely fund that is both held widely in taxable and retirement plans that would benefit from such a move since an in-kind redemption would also have the benefit of not timing the market or requiring large whale-like entries into the market, basis washing is just a positive side effect...
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