One of the best things about exchange traded funds (ETFs) has been their tax efficiency versus other investment vehicles. Thanks to how they are structured and how most investors trade them, capital gains that occur within the fund are passed through in-kind. Investors can control their own capital gains via strategic sales. This has led to being a top investment vehicle for taxable accounts.
And active ETFs can only enhance this fact.
In fact, using active ETFs in a taxable account can add additional alpha to a portfolio. According to new research from BlackRock, active ETFs can provide additional after-tax gains to portfolios. With that, there’s no reason why active ETF strategies can’t have a higher allocation in taxable accounts.
ETFs, Taxable Accounts & Tax Efficiency
For many Americans, 401k and similar accounts such as IRAs are often the first place they begin saving. After all, these accounts let you defer or—in the case of Roth accounts—pay no taxes until you withdraw the money. The only issue is many retirement accounts come with all types of penalties for early withdrawals.
This is why taxable account usage has grown exponentially over the years. With a taxable account, you can withdraw money at any time for any purpose. You can use it for retirement, education, buying a new motorcycle, or for an emergency–; it doesn’t matter when or how you tap into it. The pandemic and the uncertainty surrounding it helped usher in a new wave of needed potential liquidity for many investors.
The problem is taxable accounts are, well, taxable. That means investors need to address what happens in the account—dividends, capital gains, etc.—every year. So, it should come as no surprise the surge in taxable account adoption has come on the back of ETF adoption.
ETFs are very well suited to help reduce the taxes investors pay each year versus other investment vehicles like mutual funds. ETFs tweak the Investment Company Act of 1940 and add more layers to their structure. The key is the creation/redemption mechanism.
Here, authorized participants (APs) package the underlying stocks, bonds, or whatever into so-called creation units. The AP delivers these to the fund sponsor, who then bundles the securities into shares of the ETF. The AP then places these shares on the secondary market. The reverse happens when a manager sells assets in the fund or an AP decides to redeem their shares. They get physical assets from the sales.
Because most of us purchase ETFs on the secondary market—i.e., on an exchange—we don’t get hit with capital gains effects on what happens within the fund. Those capital gains hits can be huge. For example, over the last five years, 53% of active equity mutual funds paid out a capital gain in an average year. This compares to just 4% of index equity ETFs. As for the size, the average gain for an active mutual fund was 3.3% of its net asset value. For ETFs, this was less than 0.5%. 1
Active ETFs Could Be Even Better
The real win is active ETFs could deliver better after-tax returns and be a source of additional alpha for a portfolio. That’s the gist of a new study by investment manager BlackRock. That’s because the creation/redemption mechanism enhances the ability of managers to beat their benchmarks/indexes and generate additional returns.
Digging into the data, BlackRock found the average top quartile large-cap fund has managed to beat the S&P 500 index by 0.82% per year over the last five years. That’s not bad and shows active managers can and do beat passive benchmarks. The problem is after we consider taxes, those gains turn into losses—a 1.46% loss in fact.
Source: BlackRock
According to BlackRock, the average large-cap mutual fund has capital gains distributions that account for a 2% annual tax cost. This high hurdle is one of the areas that helps prevent many active managers from beating their passive peers. A similar study run by American Century found that tax hurdles faced by active managers may be greater and have a greater effect on returns than the so-called much-hyped fee hurdle.
But active ETFs are different.
Thanks to the previously mentioned creation/redemption mechanism inherent in all ETFs―passive or active—active ETF managers have a much lower hurdle, if any hurdle at all. This allows them to outperform their benchmarks and lets investors realize those gains, without realizing those gains’ taxes.
The proof is in the pudding. American Century data shows the average active equity ETF only handed out 0.04% in capital gains last year. Over the last five years, only 16% of large-cap active ETFs paid a capital gain last year, and that amount was just 1.2% of NAV.
That reduction is a big deal considering the top marginal tax rate includes a 40.8% federal tax on short-term gains and a 23.8% tax on long-term gains.
Adding an Extra Layer of Alpha
So, ETFs are a very efficient structure when it comes to taxes and avoiding them. The win for active ETFs is they can allow investors to add additional alpha to a portfolio. Because of their ability to beat passive funds and their ability to pay potentially no internal capital gains taxes, ETFs can beat passive benchmarks on a pre- and after-tax merit. This provides additional tax alpha to a portfolio.
Better still investors can manage their own capital gains by tax-loss harvesting their active ETF, pruning and rebalancing their portfolios. This only serves to enhance the after-tax returns in a portfolio.
Popular Active ETFs
These ETFs are sorted by their YTD total returns, which range from -2.7% to 9.7%. They have expense ratios between 0.17% and 0.36% and have assets under management between $5B and $30B. They are currently yielding between 0.8% and 9.7%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| JEPQ | J.P. Morgan Nasdaq Equity Premium Income ETF | $5.58B | 7.8% | 9.7% | 0.35% | ETF | Yes |
| DFUV | Dimensional US Marketwide Value ETF | $8.5B | 6.2% | 1.5% | 0.21% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $20.9B | 5.7% | 0.8% | 0.17% | ETF | Yes |
| JEPI | JPMorgan Equity Premium Income ETF | $29.2B | 4.1% | 7.4% | 0.35% | ETF | Yes |
| MINT | PIMCO Enhanced Short Maturity Active ETF | $9.7B | 2.1% | 5.3% | 0.35% | ETF | Yes |
| JPST | JPMorgan Ultra Short Income ETF | $22.8B | 1.7% | 5.2% | 0.18% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $6.7B | 0.80% | 1.4% | 0.25% | ETF | Yes |
| DFAT | Dimensional U.S. Targeted Value ETF | $8.2B | -0.4% | 0.8% | 0.28% | ETF | Yes |
| FBND | Fidelity Total Bond ETF | $5.1B | -2.7% | 4.9% | 0.36% | ETF | Yes |
Ultimately, active ETFs and their tax efficiency are wonderful for investors looking to use taxable accounts. Thanks to their ability to pass through capital gains, they perform much more tax efficiently than other investment vehicles. And because of their better returns, they can deliver higher gains than passive funds. To that end, a higher allocation to active ETFs in a taxable account makes a ton of sense for investors.
Bottom Line
While active management has long been a high-tax proposition, the growth of active ETFs has changed the game. After some new research, it turns out active ETFs can add some significant extra alpha to a portfolio on the tax front. For investors, that means adding a hefty dose of active ETFs to their taxable accounts.
1 BlackRock (October 2024) The Evergreen Case for a Strategic Allocation to High Yield
