Are ETFs Really More Tax-Efficient?

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Nobody likes to pay taxes. Some investors choose ETFs primarily because they want to cut their income tax bill. Yet as it turns out, exchange-traded funds don't have a monopoly on tax efficiency -- and in some cases, ETFs can turn out to create bigger tax burdens than you'd ever think possible.

Straight from the horse's mouth
You'd expect that someone trying to debunk the tax advantages of ETFs would come from outside the industry. But a recent message talking about how ETFs aren't automatically more tax-efficient than mutual funds came from a fairly surprising source: the Vanguard Group. The No. 3 player in the ETF industry took in the most new assets among ETF providers during 2010.

Now, to be fair, Vanguard has its finger in both pots of the asset management business. It has made building its ETF line a top priority, in part by giving investors the ability to buy them at no commission if they open a brokerage account with the company. But Vanguard's legacy mutual fund business is much larger and more important to the company's overall success. So if expanding on the pros and cons of ETFs helps attract some investors back to its mutual funds, Vanguard has nothing to lose and everything to gain.

Win by technicality
Vanguard's argument is pretty simple: There's nothing inherent in the structure of an ETF that makes it tax-efficient. Conversely, mutual funds aren't inherently tax-inefficient. It's all in what fund managers do with their portfolios.

With some mutual funds, big capital gains distributions are simply a fact of life. If a fund has high turnover, frequently trading old holdings for new ones and reaping profits on a regular basis, then fund shareholders will get hit with a tax bill nearly every year.

But other funds -- particularly the index funds for which Vanguard is famous -- have low turnover and don't routinely buy and sell investments. Moreover, when they do make trades, index funds can pick and choose from among different tax lots, to sell only shares that will minimize any tax impact on their shareholders. So with the ETFs Vanguard Total Stock Market (NYSE: VTI  ) and Vanguard Emerging Markets Stock (NYSE: VWO  ) , investors don't really get a major tax benefit -- because the corresponding index mutual funds have been managed so that they haven't had to distribute capital gains in more than a decade.

Not always perfect
Vanguard's point is basically what you'd expect: As long as you go with Vanguard, you'll get good tax treatment either way. That's not always true for other mutual funds or ETFs.

For instance, leveraged ETFs sometimes cause big tax headaches. During 2008, several inverse ETFs from Rydex paid out huge portions of their net asset value in capital gains -- as much as 87% in one case. Similar ProShares ETFs, including UltraShort Industrials ProShares (NYSE: SIJ  ) , UltraShort Basic Materials ProShares (NYSE: SMN  ) , and UltraShort Utilities ProShares (NYSE: SDP  ) , paid more than a third of their net assets in capital gains. That's a major tax headache even after a year in which many bearish ETFs did well.

In addition, sometimes the structure of exchange-traded products creates a tax nightmare. With United States Natural Gas (NYSE: UNG  ) and United States Oil Fund (NYSE: USO  ) , the ETFs are set up as partnerships that report their taxable income on special tax forms called K-1s. They're a lot more complicated than the ordinary dividend tax forms you usually get with stocks and funds, and they can turn a reasonable investment into a major hassle.

Be tax smart
Taxes aren't the most important thing about making an investment, but they definitely play an important role. Before you jump into ETFs based on a promise that they're more tax-efficient, be sure to check into them and their alternatives. You may well find that you're better off going with another investment.

ETFs aren't just for tax benefits; they can make you rich, too. To pick the right ones, read The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."

Fool contributor Dan Caplinger is a big fan of ETFs. He and the Fool both own shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy loves efficiency.

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