US investors have saved $250bn by investing in ETFs, says BofA

US investors have saved $250bn by investing in exchange traded funds rather than traditional mutual funds, since their creation in 1993, according to calculations by Bank of America.

The sum is equivalent to 2.5 per cent of the $10tn US-listed ETF market.

The savings stem in part from the lower fees typically levied by ETFs, but primarily from the tax advantages enjoyed by ETFs under America’s unusual tax system.

The average total expense ratio for ETFs in the US is just 0.16 per cent of assets, according to BofA, compared with 0.44 per cent for mutual funds. However, while welcome, the benefit of lower fees is swamped by the tax savings typically available to ETF investors.

ETF investors have, on average, incurred a “tax drag” equivalent to 0.36 per cent of their assets per year, a fraction of the 1.28 per cent incurred by those investing in mutual funds, BofA found.

Mutual funds’ elevated capital gains tax liability stems from their need to engage in “cash” transactions. When investors want to sell their units, the fund sells a slice of its underlying holdings. If these holdings have appreciated since the fund purchased them, a capital gains tax liability is triggered for the fund and all of its investors, even those who are not redeeming.

This liability can also be triggered whenever the fund manager makes changes to the underlying portfolio.

In contrast, when faced with redemption requests, ETFs do not unusually need to sell their underlying securities. Instead, they can deliver baskets of stock “in-kind” to their “authorised participants”, the market makers that create and redeem shares in ETFs.

As a result, the trading activity, and any resultant capital gain, occurs outside the fund so there is no pass-through to the end investor.

Moreover, since most ETFs passively track their underlying index, they also typically trade less than mutual funds, which are more likely to be actively managed, limiting portfolio turnover.

ETFs’ greater tax efficiency does mean that investors are likely to pay more capital gains tax when they eventually sell their holdings, but these are more likely to be counted as long-term capital gains, which are taxed more lightly than the short-term gains often unavoidably incurred by mutual funds.   

ETFs can still be liable for capital gains in unusual circumstances, for example if they need to drastically rebalance their portfolio due to substantial changes in their underlying benchmark.

However, last year Morningstar found that of the 1,854 US-listed ETFs managed by 15 of the largest issuers, just 24 distributed capital gains. The highest of these was the 8.5 per cent of net asset value distributed by the iShares MSCI Taiwan ETF, which operates in a market where in-kind transactions are not permitted.

In contrast, Morningstar’s recently published mutual fund estimates point to 50 funds having a distribution equal to at least 14 per cent of assets, with the Morgan Stanley Institutional Fund Trust Dynamic Value vehicle top of the list at 52.7 per cent.

Stephen Welch, senior manager research analyst at Morningstar, attributed the chunky tax liabilities to a combination of strong equity markets and sizeable outflows from some funds.

“With the ongoing trend of investors swapping actively managed stock funds for passive ETF offerings, many managers have had to realise gains to meet redemptions,” he said.

“The common theme among most of these top 50 funds is outflows. Almost all the funds in the top 10 have had substantial outflows so far in 2024, typically above 30 per cent of assets.”

While active managers typically have higher portfolio turnover and thus sell more winning positions, incurring more tax liabilities, Welch also noted that passive funds were not immune to this.

For example, this year’s stock splits at chipmakers Nvidia and Broadcom cut their weightings in the price-weighted NYSE Arca Technology 100 index, meaning the Nationwide NYSE Arca Technology 100 index, which tracks this benchmark, needed to cut its lucrative stakes.

“This forced the strategy to realise large capital gains in those holdings, and the fund will distribute roughly 20 per cent this year,” Welch said.

Average distributions are comfortably lower — median distributions at the largest fund houses are nearer 6-7 per cent.

Nevertheless, combining the lower fees and greater tax efficiency of ETFs, BofA concluded that their “all in” costs have averaged 0.52 basis points a year, a fraction of the 1.72 per cent cost of mutual funds.

Jared Woodard, investment and ETF strategist at BofA Securities, calculated that ETF investors had saved $250bn since 1993 as a result, even though 57 per cent of mutual funds are currently held in tax-sheltered retirement accounts, and are thus immune from capital gains tax.

As an example, Woodard said an investor who bought $100,000 of an S&P 500 ETF in October 2013 would now have $359,000, compared with $316,000 if the investment was in a non-tax exempt S&P 500 mutual fund.

The savings from ETFs are only likely to rise further as investors increasingly adopt the format.

US-domiciled long-term mutual funds (ie, excluding money market funds) have seen net outflows in nine of the past 10 years, according to data from the Investment Company Institute, even as ETFs have seen constant inflows.

Over the past decade investors have pulled more than $2tn from domestic equity mutual funds alone, the ICI found, while pumping a similar sum into domestic equity ETFs. 

There have been sporadic suggestions in the past that some politicians may wish to address the anomalous tax treatment of the different fund structures — something that could become more pressing if the rise of ETFs continues to eat into tax revenues — but these appear to have petered out for now.