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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

“Wrapper swaps”: ditching mutual funds for ETFs

Many investors may be aware that the structure of an exchange traded funds or ETF is in general more tax efficient than a traditional mutual fund, but the carnage in bonds this year has prompted action. Through October, over $450 billion has exited bond mutual funds according to the Investment Company Institute. During that period, $157 billion has flowed into bond ETFs in a move referred to as a wrapper swap, maintaining exposure to the bond market but seeking a more tax friendly vehicle.

For many holders of mutual funds in non-retirement accounts, December brought a nasty surprise: double digit losses in funds compounded by taxable capital gains distributions. For those seeking broad stock and bond exposure, the ETF structure offers some advantages to tax-sensitive investors.

For starters, most ETFs are passive, constructed to mimic an equity index like the S&P 500 or a bond benchmark like the Bloomberg Aggregate Bond Index. Trades within an index ETF occur only when constituents in the underlying index change, a relatively rare event. Most traditional mutual funds, on the other hand, are actively managed and may execute hundreds of trades over the course of a year. More trades mean more transaction costs and higher fees, which is relevant since few active funds consistently beat passive indexes over time, notwithstanding any tax implications. Many researchers have demonstrated a correlation between higher turnover and lower returns.

More importantly, each time a fund sells a security it must recognize a gain or loss on the position that is passed along to the holders at least yearly. A typical actively-managed US equity mutual fund has a turnover ratio of over 50%, implying that about half of the holdings are sold over the course of a year, generating taxable events for holders. Some equity funds sport turnover ratios in excess of 1,000%. Meanwhile, passive equity index ETF turnover seldom exceeds 5%.

Low turnover and expenses are beneficial to investors in taxable and retirement accounts as well, increasing net compounded returns over time. But by far the biggest factor favoring ETFs from a tax perspective is the fundamental difference in the structure of exchange traded funds versus mutual funds.

Traditional mutual funds, known as “open end” funds, do not trade actively on stock or bond markets. Each day, as the fund receives cash inflows from new investors, it creates new shares that represent the proportional interest in the pool, and invests the cash received into the underlying portfolio. The fund is valued each day after the markets close by adding up the individual prices of all the holdings. That total is called the “net asset value” and is recomputed each day. So far, so good.

What if fund holders want out? The fund must then sell enough of the portfolio to raise the cash, recognizing a gain or loss on the positions sold. Throughout the year, these gains and losses are accumulated, and are distributed to shareholders still hanging around at the end of the year. Steep redemptions in 2022 required forced selling, often of securities with long term gains. In many cases remaining holders received a Christmas gift of capital gains taxes despite the fact that their funds were under water for the year.

ETF shares also represent a fractional interest in a portfolio but are structurally quite different. Shares are created by banks based upon demand in the marketplace and are not created and destroyed each day according to redemptions. Instead, investors buy and sell ETF shares throughout the trading day on exchanges just like individual stocks. Capital gains or losses are realized when ETF shares are sold and are based upon the cost of the shares and the holding period, just like common stocks. Generally, year-end gain distributions are few in index ETFs and the investor has much more control over when (or whether) to pay taxes.

2022 has provided a unique opportunity for taxable bond mutual fund investors to offset capital gain distributions by harvesting capital losses and swapping wrappers into a similar ETF structure, as long as the two funds are not substantially identical.

An important caveat applies. The discussion here pertains to passive index ETF strategies, but there are an increasing number of actively managed exchange traded funds that have higher turnover and potentially greater exposure to tax distributions. Some precious metals ETFs that offer exposure to gold and silver are taxed as collectibles and are subject to a higher tax rate. Many commodity ETFs are structured as limited partnerships and generate K-1s which can complicate tax filing. Commodity funds also use futures contracts and can distribute gains and losses as contracts expire and are replaced. And some critters that look a lot like ETFs are actually a type of bond that exposes the investor to the credit risk of the issuing bank. These products are called Exchange Traded Notes or ETNs and should generally be avoided unless you thoroughly understand the risks.

The universe of exchange traded funds has expanded dramatically, and for average investors seeking passive exposure to diversified stock and bond market returns, the ETF structure may provide better net returns and inflict less pain at tax time.

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