The August 24, 2006 edition of the Wall Street Journal featured an article by Eleanor Laise entitled "A Surprise Hit For Small Investors" (subscription required). The article is noteworthy in that it indirectly highlights several of the advantages of exchange-traded funds (ETFs). The article discusses how manager turnover in an actively managed mutual fund inevitably leads to portfolio shifts which trigger capital gain income taxes.
The relevant points are highlighted in the following excerpt:
A change in fund managers could lead to higher tax bills for investors. Here's what they should watch for:
• New managers often dump unwanted holdings, triggering taxable capital-gains distributions.
• Investors sometimes flee funds that change managers, which could aggravate any tax hit for shareholders.
• Some types of funds, including index funds, are typically able to change managers without resulting in big distributions to investors.
One of the advantages of ETFs is that they are more tax efficient than traditional mutual funds. Since ETFs are generally pure index funds, there is little concern about manager turnover. Further, ETFs have lower portfolio turnover and fewer capital gains since portfolio changes would typically only occur with changes in the relevant index or basket of securities. Exchange trading of ETFs further enhances their tax efficiency since ETFs are not required to sell securities to meet shareholder redemptions. In a traditional mutual fund, the fund must sell securities to redeem mutual fund shares from fleeing investors. Such forced security sales may generate additional capital gains for the remaining mutual fund shareholders.
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