What is the real difference of an Index Fund vs an ETF in a taxable account ?

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Kumsajack
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What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Kumsajack »

I continually read the mantra regarding the tax efficiency of ETF, which makes sense for most mutual funds. But what is the real world difference, especially between and index fund and an ETF ?

For example, say $100k in FNILX (Fidelity® ZERO Large Cap Index Fund) and the same in VOO (Vanguard 500 Index Fund ETF).

What is it that I would be measuring to calculate and compare their tax efficiency ?

Thanks !
rich126
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by rich126 »

Fidelity has a page on this stuff.
https://www.fidelity.com/learning-cente ... efficiency

At one time I thought Morningstar showed tax efficiency of funds but maybe I am imaging things because I don't see it anymore.
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Kumsajack
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Kumsajack »

So the Fidelity info is more about mutual funds, not index mutual funds.

In a similar Forbes article, https://www.forbes.com/advisor/investin ... index-fund, that is specific about index fund vs ETF, the following is stated:
While you will pay capital gains taxes on any gains you realize when you sell shares of an index fund or an ETF, you do not pay taxes when the holdings in the ETF portfolio are adjusted by managers.

Index funds, on the other hand, must buy and sell assets to adjust their portfolio to track the underlying index. The cost of any capital gains taxes from these sales are taken out of the fund portfolio NAV, which impacts the value of your index fund shares. That said, index fund holdings rarely change, so this may not be a huge issue for you. [emphasis mine]
Which means, maybe the tax efficiency between the two asset classes can be larger or smaller depending on how often the index fund holdings are changed.

So, to keep the discussion grounded (and avoiding other sub-topics like qualified dividends), I'm curious how anyone can measure the tax efficiency between FZNILX and VOO.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by muffins14 »

I have never calculated it and I assume it’s a very small benefit. Maybe 1-5 basis points max?

The bigger thing is perhaps that you can sell ETFs intra-day at a known transaction price, so when tax loss harvesting you probably stand to benefit much more than the tax efficiency difference alone
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MrJedi
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by MrJedi »

The difference is in capital gains distributions. ETFs can mostly eliminate those, whereas mutual funds cannot do that as effectively. Look up capital gains distributions for the funds you are interested in. And yes, for an index fund, it should be relatively low because there should be low amounts of turnover by nature of following an index rather than stock picking.
zie
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by zie »

First, VOO and FNILX are both index funds, as in they both follow an index. FNILX follows a Fidelity created index and VOO follows the S&P500 index, but they are nearly identical in companies in the index, so they are basically equal in that way.

Mutual Funds like FNILX are usually less tax efficient, because when they sell, they are forced to pass their capital gains on to all share holders. ETF's, like VOO when they sell something, they can usually pass the capital gains off to the buyer and not to the share holders.

This is basically all there is. It's a weird technical quirk.

Mutual Funds have gotten pretty good at avoiding selling things worth lots of money and/or offsetting with losses when they sell, so in practice, most of the time, for a well run fund, that usually has more inflows than outflows, they are mostly the same.

The problem is, not all funds are well run with more inflows than outflows, that dynamic is not guaranteed to continue forever. Assuming no tax law changes that put them both on equal footing, an ETF will almost certainly win in tax efficiency eventually.

Personally, my perspective is that most people's taxable accounts will be small to non-existent anyway, so for most people it does not matter at all which you pick.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Northern Flicker »

Kumsajack wrote: Wed Jun 07, 2023 1:07 pm I continually read the mantra regarding the tax efficiency of ETF, which makes sense for most mutual funds. But what is the real world difference, especially between and index fund and an ETF ?

For example, say $100k in FNILX (Fidelity® ZERO Large Cap Index Fund) and the same in VOO (Vanguard 500 Index Fund ETF).

What is it that I would be measuring to calculate and compare their tax efficiency ?

Thanks !
The index mutual fund has fewer mechanisms than an ETF (or Vanguard dual/multiple share class index fund) to manage capital gains. Index mutual funds are tax-efficient, and may not distribute capital gains every year, but such funds, including Fidelity index mutual funds, have distributed capital gains in the past.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by alex_686 »

Funds can be either actively or passively (indexed) managed. Index funds tend to be more tax efficient.

Funds can either be mutual funds or ETFs. ETFs hace a larger tool kit to manage tax issues. As such, between equivalent funds, ETFs are the absolute better choice.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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Kumsajack
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Kumsajack »

Looking at Mr Jedi's comment, I'm examining what I can find on the capital gains distribution between these two funds. The last capital gains distribution from Fidelity was in 2018. For Vanguard, it's every quarter (I only show the most recent distribution).

FNILX https://fundresearch.fidelity.com/mutua ... e=o-NavBar:

Code: Select all

Date	     Per Share Amount   Reinvestment Price
12/28/2018   $0.011	        $8.56 
VOO https://investor.vanguard.com/investmen ... tributions

Code: Select all

Dividend income and capital gains
Type       $/Share	Payable date	Record date	Ex-dividend date
Dividend   $1.487400	03/29/2023	03/27/2023	03/24/2023 
Am I to understand that, for example, had I invested $100k in FNILX over the 12 months, that it would have been more tax efficient than VOO ?
toddthebod
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by toddthebod »

Kumsajack wrote: Wed Jun 07, 2023 1:07 pm I continually read the mantra regarding the tax efficiency of ETF, which makes sense for most mutual funds. But what is the real world difference, especially between and index fund and an ETF ?

For example, say $100k in FNILX (Fidelity® ZERO Large Cap Index Fund) and the same in VOO (Vanguard 500 Index Fund ETF).

What is it that I would be measuring to calculate and compare their tax efficiency ?

Thanks !
And although you did not ask it, pretty much everyone on this board would recommend against holding a proprietary fund like the Fidelity Zero funds which cannot be held at any other brokerage in a taxable account. You will never be able to transfer the funds out of Fidelity, so if the day comes when you want to switch brokerages, you will have to sell and likely incur substantial capital gains.
toddthebod
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by toddthebod »

Kumsajack wrote: Wed Jun 07, 2023 2:36 pm Looking at Mr Jedi's comment, I'm examining what I can find on the capital gains distribution between these two funds. The last capital gains distribution from Fidelity was in 2018. For Vanguard, it's every quarter (I only show the most recent distribution).

FNILX https://fundresearch.fidelity.com/mutua ... e=o-NavBar:

Code: Select all

Date	     Per Share Amount   Reinvestment Price
12/28/2018   $0.011	        $8.56 
VOO https://investor.vanguard.com/investmen ... tributions

Code: Select all

Dividend income and capital gains
Type       $/Share	Payable date	Record date	Ex-dividend date
Dividend   $1.487400	03/29/2023	03/27/2023	03/24/2023 
Am I to understand that, for example, had I invested $100k in FNILX over the 12 months, that it would have been more tax efficient than VOO ?
You are looking at capital gains for Fidelity and dividends for Vanguard.
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retiredjg
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by retiredjg »

So, to keep the discussion grounded (and avoiding other sub-topics like qualified dividends), I'm curious how anyone can measure the tax efficiency between FZNILX and VOO.
Well, qualified dividends is part of tax efficiency, but....

Here is how I compare tax costs. I think it is "right", but I know little about how it actually works.

Go to the fund family website and look up the fund you are interested in.

https://fundresearch.fidelity.com/mutua ... /315911628

https://investor.vanguard.com/investmen ... o#overview

On the website, often under performance, find something that looks like "before tax" and "after tax on distributions". Every website does it differently. In this case, look at 3 year costs (because that's about how old the zero fund is).

For FNILKX, this is found in a box labeled Quarter-End Average Annual Total Returns. You will find that before tax is 18.25% and after tax on distribution is 17.90%. Subtract the second number from the first to get a tax cost. For FNILX the tax cost at over the 3 years was 0.35%. The lower the number, the more tax efficient the fund is.

For VOO, click on the pretty invisible link for "Quarterly After-tax Returns (under Performance). The numbers at 3 years were 18.55% and 18.10%. The difference is 0.45%.

The 500 index tax cost is slightly higher than the tax cost for the zero fund, but not really enough to matter a lot. Both are very tax efficient and these numbers change every year. The next 3 years, the reverse might be true and 500 index might be a little more tax-efficient. As far as tax-efficiency goes, either is fine in a taxable account.

In order to get a feeling for other funds, do this with different asset classes. The information is easiest (for me) to find on the Vanguard site, so compare a lot of different Vanguard funds and asset classes. Be sure to include bonds and REITs. You'll get a feel for what belongs in taxable and what does not.

However, I would not hold any Fidelity zero fund in taxable because there might come a time when I want to switch brokerages. You cannot move a Fidelity zero fund anywhere else, so you would have to sell it and pay taxes in order to move your money. In taxable, I'd hold the Fidelity total stock index fund.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by MrJedi »

Kumsajack wrote: Wed Jun 07, 2023 2:36 pm Looking at Mr Jedi's comment, I'm examining what I can find on the capital gains distribution between these two funds. The last capital gains distribution from Fidelity was in 2018. For Vanguard, it's every quarter (I only show the most recent distribution).

FNILX https://fundresearch.fidelity.com/mutua ... e=o-NavBar:

Code: Select all

Date	     Per Share Amount   Reinvestment Price
12/28/2018   $0.011	        $8.56 
VOO https://investor.vanguard.com/investmen ... tributions

Code: Select all

Dividend income and capital gains
Type       $/Share	Payable date	Record date	Ex-dividend date
Dividend   $1.487400	03/29/2023	03/27/2023	03/24/2023 
Am I to understand that, for example, had I invested $100k in FNILX over the 12 months, that it would have been more tax efficient than VOO ?
I don't think VOO has ever distributed capital gains. You are looking at dividend distributions. Neither mutual funds or ETFs can avoid those.
wellboy99
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by wellboy99 »

1. ETF is cheaper than its own MF class.
2. ETF can easily find a pair for TLH, while MF can be hard to find one within the same fund family.
3. ETF can be bought/sold intraday or with close-at-market order, while MF only close-at-market.
4. ETF can trade with no limit, while MF often has frequent trade limitations.
5. ETF can TLH into MF by selling right before marker close and placing a MF buy order, while MF cannot TLH into ETF without waiting the next day.

To me, ETF is preferrable in taxable account.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Morik »

For clarity, let's define a few terms:

Index: A collection of investments on paper. I.e., you cannot buy this directly, it is just a collection of investments selected via some criteria. E.g., the S&P 500 is an index.

Index fund: An investable collection of investments that tries to track an index. This implies passive management rather than active stock picking. VOO, SPY, VFIAX, FXAIX are all examples of an index fund.

The above terms relate to 'what' the investment is.


Mutual Fund vs ETF more relate to the packaging that the underlying investments are in -- whether it's an ETF or a mutual fund, it holds the same stuff (e.g., VOO vs VFIAX have the same holdings), but the way you buy & sell them is different.
ETFs do have some underlying details that can make them more tax efficient than a mutual fund tracking the same index. A mutual fund may have to distribute capital gains, while an ETF can work around that and not distribute the gain (so no taxable event in a taxable account). E.g., if the mutual fund has a NAV of $100 per share, and has to distribute a $1 cap gain per share, the new NAV is $99 and you receive (taxable) cash of $1/share. Whereas the ETF can just keep its NAV at $100/share and not distribute that dollar.

Vanguard has a method that allows them to provide the similar (same? I'm not sure) tax efficiency in mutual funds that they have in ETFs. See https://www.investopedia.com/how-vangua ... ds-4686985 for more info on that.

Note that there are ETFs & Mutual funds that are NOT index funds. I.e., they do not passively follow an external index, instead their managers actively choose what collection of investments to hold.


TL;DR:
Index & Index fund relate to the contents of an investment.
ETF and Mutual fund relate to the packaging of those contents (but note that there are also ETFs and Mutual Funds that are 'active' rather than following an index).
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Northern Flicker »

Kumsajack wrote: Wed Jun 07, 2023 2:36 pm Looking at Mr Jedi's comment, I'm examining what I can find on the capital gains distribution between these two funds. The last capital gains distribution from Fidelity was in 2018. For Vanguard, it's every quarter (I only show the most recent distribution).

FNILX https://fundresearch.fidelity.com/mutua ... e=o-NavBar:

Code: Select all

Date	     Per Share Amount   Reinvestment Price
12/28/2018   $0.011	        $8.56 
VOO https://investor.vanguard.com/investmen ... tributions

Code: Select all

Dividend income and capital gains
Type       $/Share	Payable date	Record date	Ex-dividend date
Dividend   $1.487400	03/29/2023	03/27/2023	03/24/2023 
Am I to understand that, for example, had I invested $100k in FNILX over the 12 months, that it would have been more tax efficient than VOO ?
You are looking at a dividend distribution for the Vanguard fund VOO, not a capital gains distribution. I doubt that VOO has ever distributed capital gains.
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Kumsajack
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Kumsajack »

Thank you so much for the clarification on the "real difference of an Index Fund vs an ETF in a taxable account."

All the comments about the disadvantages of a proprietary Fidelity index fund are to be well noted, but the purpose of my questioning a tax-efficiency bake-off between FNILX and VOO was to highlight the real world difference in index funds vs ETF in tax efficiencies.

I'm in agreement (and educated) by RetiredJG on how to identify and quantify the tax cost. It's a little puzzling what to be looking for, and especially as different providers display "something that looks like "before tax" and "after tax on distributions". I'm also in agreement that As far as tax-efficiency goes, either is fine in a taxable account.

This forum is always an incredible resource. I'm looking forward to being at the Bogleheads conference !
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by Northern Flicker »

Kumsajack wrote: Wed Jun 07, 2023 9:10 pm Thank you so much for the clarification on the "real difference of an Index Fund vs an ETF in a taxable account."

All the comments about the disadvantages of a proprietary Fidelity index fund are to be well noted, but the purpose of my questioning a tax-efficiency bake-off between FNILX and VOO was to highlight the real world difference in index funds vs ETF in tax efficiencies.

I'm in agreement (and educated) by RetiredJG on how to identify and quantify the tax cost. It's a little puzzling what to be looking for, and especially as different providers display "something that looks like "before tax" and "after tax on distributions". I'm also in agreement that As far as tax-efficiency goes, either is fine in a taxable account.

This forum is always an incredible resource. I'm looking forward to being at the Bogleheads conference !
I rarely fund the after-tax return or tax cost published by the fund company to be useful. It may not use your tax brackets in the determination, and it is about what happened in the past, not what may happen in the future.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by beyou »

rich126 wrote: Wed Jun 07, 2023 1:15 pm Fidelity has a page on this stuff.
https://www.fidelity.com/learning-cente ... efficiency

At one time I thought Morningstar showed tax efficiency of funds but maybe I am imaging things because I don't see it anymore.
tax cost ratio is under PRICE for a fund.

Looking at 5/31/2023 data VTI has a higher tax cost ratio 0.53 vs the admiral fund VTSAX 0.37
Strange in that people assume the tax cost is lower for ETFs.

Regardless I use the ETF because
1) I want intraday valuation and trading when I rebalance
2) lower ER
3) portability to any brokerage if I so choose

From a tax perspective not sure how/why the tax cost ratios differ so much.
The potential capital gain (on same page in M*) is the same.
The div yields of the two are very close.
I do not recall getting cap gains distributions on either VTSAX nor VTI in recent years.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by retiredjg »

Northern Flicker wrote: Thu Jun 08, 2023 12:32 am I rarely fund the after-tax return or tax cost published by the fund company to be useful. It may not use your tax brackets in the determination, and it is about what happened in the past, not what may happen in the future.
I agree the information is of limited use. It is calculated at a different tax rate than mine and it is about the past, not the future.

However, knowing something about tax-efficiency...or rather realtive tax efficiency between different funds or different asset classes...is useful. Is there another way?

My understanding (from grabiner who tends to know things like this) is that the numbers given by Morningstar are not reliable because M* does not know the percentage of qualified dividends.
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by retiredjg »

beyou wrote: Thu Jun 08, 2023 1:05 am
rich126 wrote: Wed Jun 07, 2023 1:15 pm Fidelity has a page on this stuff.
https://www.fidelity.com/learning-cente ... efficiency

At one time I thought Morningstar showed tax efficiency of funds but maybe I am imaging things because I don't see it anymore.
tax cost ratio is under PRICE for a fund.

Looking at 5/31/2023 data VTI has a higher tax cost ratio 0.53 vs the admiral fund VTSAX 0.37
Strange in that people assume the tax cost is lower for ETFs.
This is consistent with grabiner's point I mentioned above. If you look up the numbers on the Vanguard website, the tax costs are almost identical for 1, 3, 5 and 10 years.

VTI .38, .44, .45, .49
VTSAX .38, .44,.46, .49
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by EnjoyIt »

toddthebod wrote: Wed Jun 07, 2023 2:40 pm
Kumsajack wrote: Wed Jun 07, 2023 1:07 pm I continually read the mantra regarding the tax efficiency of ETF, which makes sense for most mutual funds. But what is the real world difference, especially between and index fund and an ETF ?

For example, say $100k in FNILX (Fidelity® ZERO Large Cap Index Fund) and the same in VOO (Vanguard 500 Index Fund ETF).

What is it that I would be measuring to calculate and compare their tax efficiency ?

Thanks !
And although you did not ask it, pretty much everyone on this board would recommend against holding a proprietary fund like the Fidelity Zero funds which cannot be held at any other brokerage in a taxable account. You will never be able to transfer the funds out of Fidelity, so if the day comes when you want to switch brokerages, you will have to sell and likely incur substantial capital gains.
I just wanted to reinforce the above.

The fidelity zero fund is a perfectly good fund inside tax protected accounts. I would never own it in a taxable account for the reason stated above.
A time to EVALUATE your jitters: | viewtopic.php?p=1139732#p1139732
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by hkcj »

I think there are lots of good thoughts to summarize here:
  • Vanguard is unique in that some funds have both mutual fund and etfs as separate share classes. Those mutual funds get the benefits of the ETFs so aren't a good comparison point (e.g. VFIAX ~= VOO in terms of tax efficiency).
  • Fidelity ZERO funds lock you in to fidelity in a taxable account (you'd have to sell them to leave Fidelity)
  • Morningstar data isn't reliable on tax load.
  • The data previously shown compared Fidelity cap gains to Vanguard dividends.
In terms of attempting my own contributions to this discussion - after-tax data for Fidelity & Vanguard seem to use a similar methodology:
Vanguard wrote:After-tax returns are calculated using the highest individual federal income tax rates in effect at the time of each distribution. They don't reflect the impact of state and local taxes.
Fidelity wrote:Post tax return is calculated using the historical maximum federal individual marginal income tax rates associated with fund distributions and assume that an investor continued to hold the shares. Therefore, they do not reflect the federal income tax impact of gains or losses recognized when fund's shares are sold. These returns do not reflect the impact of state and local taxes.
I'd feel reasonably comfortable looking at those if your rates are high.

For a like-like data comparison, two S&P 500 funds seem reasonable. My metric approximation here is to divide STCG or LTCG distributions by the reinvest NAV (the numbers easily available) and then sum them and call it a "cumulative percent distribution" ("C%D"?). I'm not saying that's what it is, and it doesn't reflect lost gains on those, etc., but it's the best I could think of in a short time and with easy data.
  • VFIAX / VOO have not had a capital gains distribution in 10 years. (0 "C%D" - data here)
  • FXAIX distributed 0.27 "C%D" as STCG and 2.01 "C%D" as LTCG over the same period. (Specifically 2014-2019 - data.)
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by beyou »

retiredjg wrote: Thu Jun 08, 2023 6:20 am
beyou wrote: Thu Jun 08, 2023 1:05 am
rich126 wrote: Wed Jun 07, 2023 1:15 pm Fidelity has a page on this stuff.
https://www.fidelity.com/learning-cente ... efficiency

At one time I thought Morningstar showed tax efficiency of funds but maybe I am imaging things because I don't see it anymore.
tax cost ratio is under PRICE for a fund.

Looking at 5/31/2023 data VTI has a higher tax cost ratio 0.53 vs the admiral fund VTSAX 0.37
Strange in that people assume the tax cost is lower for ETFs.
This is consistent with grabiner's point I mentioned above. If you look up the numbers on the Vanguard website, the tax costs are almost identical for 1, 3, 5 and 10 years.

VTI .38, .44, .45, .49
VTSAX .38, .44,.46, .49
Well not knowing % qualified could certainly introduce inaccuracy, but should be same inaccuracy for etf and fund equivalent.

Having worked in the fund industry myself, in IT, we provided M* data, though I do not recall this detail about qualified vs non qualified divs. But point is M* can’t be more accurate than Vanguard !
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Re: What is the real difference of an Index Fund vs an ETF in a taxable account ?

Post by grabiner »

Kumsajack wrote: Wed Jun 07, 2023 2:04 pm So the Fidelity info is more about mutual funds, not index mutual funds.

In a similar Forbes article, https://www.forbes.com/advisor/investin ... index-fund, that is specific about index fund vs ETF, the following is stated:
While you will pay capital gains taxes on any gains you realize when you sell shares of an index fund or an ETF, you do not pay taxes when the holdings in the ETF portfolio are adjusted by managers.

Index funds, on the other hand, must buy and sell assets to adjust their portfolio to track the underlying index. The cost of any capital gains taxes from these sales are taken out of the fund portfolio NAV, which impacts the value of your index fund shares. That said, index fund holdings rarely change, so this may not be a huge issue for you. [emphasis mine]
And neither of these is correct.

Index funds, whether mutual funds or ETFs, must buy and sell assets in order to track changes in an index. ETFs do realize capital gains or losses when they adjust their portfolios; however, the creation-redemption process usually allows them to realize more losses than gains, and thus not distribute only gains. Only three times in Vanguard's history of ETFs has a diversified stock ETF distributed a capital gain. (And at Vanguard, the ETF is a share class of the mutual fund, allowing the mutual fund to get the same tax benefit.)

Whether an index fund's holdings change, and how they change depends on the index. Small-cap indexes must sell stocks which have become large-cap; before the development of ETFs, it was common for small-cap mutual fund indexes to distribute significant capital gains. Large-cap non-ETF indexes tend to have low turnover, and may have capital losses when they sell stocks that have become too small for the index.
Wiki David Grabiner
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