income tax: mutual funds vs. ETFs

Plain-vanilla corporations in the US have their income taxed by the government in the year when the profits are recognized. If the company distributes part of those profits to shareholders as a dividend, the dividend is seen by the IRS as income for shareholders and, despite having been taxed once, is taxed again.

Mutual funds and ETFs are a special type of corporation. Their profits are not regarded as taxable income at the corporate level, and are only taxed on distribution, as shareholder income. In return for this exemption from corporate tax, mutual funds and ETFs must have a narrowly focused business purpose and must distribute virtually all their yearly income to shareholders.

Mutual funds and ETFs, however, can be very different from one another as far as distributions go, in a way that I didn’t understand at first and which can be important for us as shareholders. It has to do with how redemptions are handled.

Let’s take an ETF and a mutual fund and assume:

–each has large unrealized profits from investments made years ago (think: MSFT bought in 2014 and up by 9x since) and no cash on hand.

A traditional mutual fund has $10 million in redemptions from a long-time shareholder. It sells MSFT to get the money needed, realizing a $9 million capital gain doing so. At the end of the fiscal year, normally in October, the mutual fund distributes to each shareholder at that time their proportionate share of the MSFT gain that they must pay income tax on. It isn’t the selling shareholder who pays, even though he has most likely benefitted substantially from the 9x gain on MSFT. It’s the holder of the mutual fund shares at the time of the distribution, even if he has only bought the mutual fund shares on October 30th, who is responsible for paying the tax.

An ETF, on the other hand, does not deal directly with its shareholders. Instead, the ETF designates a small group of market-makers, typically large brokerage houses, as intermediaries to handle buying and selling. In particular, in the case of redemptions, the intermediary can present shares for redemption to the ETF and receive stock held by the ETF in exchange, instead of cash. The details of how much and how this is done are spelled out in the contract between the ETF and the intermediary. To the extent the ETF delivers stock, it it is not selling, and therefore not realizing capital gains.

This characteristic of STFs is a big reason, I think, that mutual fund complexes are beginning to convert their actively-managed offerings into ETFs. A second is that something like half the fees charged by mutual funds go to support the in-house agency that handles buy and sell orders and keeps the fund’s records. I don’t know how that compares with the bid-asked spread that ETF intermediaries maintain, but that’s invisible to shareholders while the mutual fund administrative expenses aren’t.

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