How much more tax-wise are ETFs vs mutual funds?
Summary
We looked at the difference in post tax returns between mutual funds and exchange-traded funds. Here’s what we found
Investors often hear that because of tax-efficient structural features, exchange-traded funds generally offer better after-tax returns than mutual funds.
But many don’t know the exact magnitude of those tax savings. It is not insignificant.
We decided to quantify just how much posttax performance in a taxable account can be juiced by an ETF as opposed to a mutual fund. On average, our findings show, an ETF gives an extra 0.20 percentage point a year in posttax performance compared with mutual funds, and international-equity ETFs even more—upward of 0.33 percentage point on average.
(Last month, we wrote about our study of mutual-fund tax efficiency specifically, and the finding that high turnover doesn’t necessarily mean less tax efficiency.)
To explore the tax efficiency of ETFs vs. mutual funds further, my research assistants (Mason Leppa, Dhruv Dewan) and I pulled posttax return data for all U.S.-dollar-denominated ETFs and mutual funds. We then matched each ETF to its corresponding index mutual fund.
To be matched for comparison, the mutual fund and the ETF needed to be from the same fund family, have the same objective and have a similar cost structure. We created roughly 10 matched pairs in each of six different asset classes: U.S. large-cap equity, U.S. small-cap equity, value, growth, international equity and fixed income.
The findings
Looking at each matched pair in all of the groupings, we then recorded the average annualized posttax returns for the mutual fund and the ETF over the past 10 years.
The first interesting finding is that the average U.S. large-cap equity ETF delivered a posttax return of 10.11% a year for the period. The average matched mutual fund delivered a posttax return of 9.95% a year.
This implies that an investor can save 0.16 percentage point a year on a posttax basis by going with the large-cap ETF as opposed to the similar mutual fund.
International flavor
Next we observed more extreme results in the international-equity matched pairs.
The average international-equity ETF delivered a posttax return of 2.75% a year. The average matched mutual fund delivered a posttax return of 2.42% a year over the same period. This yields a posttax difference in returns of 0.33 percentage point a year—or more than 1 percentage point in excess returns over a three-year period.
The results associated with bond and other fixed-income assets offer a slightly different picture. The average fixed-income ETF delivered a posttax return of 0.15% a year over the past 10 years. The average matched mutual fund delivered a posttax return of 0.12% a year over the same period; a difference of just 0.03 percentage point.
The greater posttax return that ETFs offer on average, though seemingly small, is important to note and can add up quickly over time—more than a percentage point in extra returns after just five years.
And for those who do a majority of their savings in taxable brokerage accounts, this result should definitely be heeded.
