Morningstar - Winter 2019 - 50

Strategies

EXHIBIT 2

Mutual Fund Investors Transact Directly With Funds

Investors
(Buyers)

Fund Shares

2 There is the opportunity cost of holding cash

Customer Service

Cash

from the manager (for example, their purchases
push prices higher).

Cash

Securities

Fund

Capital Markets

Source: Morningstar.

to meet regular redemptions. Many managers will
keep a cash stake so they won't have to
regularly sell securities to raise cash to facilitate
redemptions. This cash balance can weigh on
performance during bull markets.

Cash

Customer Service

3 Taxable capital gains distributions are also a

Even Investors
low-turnover index funds can be quite
tax-inefficient
(Buyers) if the circumstances are just right.
For example, Federated Max-Cap Index FISPX,
Fund Shares
which tracks the S&P 500, distributed 46%
of its net asset value as capital gains in 2018. Four
other mutual funds tied to cap-weighted
benchmarks made capital gains distributions of
more than 20% of NAV in 2018 as well. While
many of the largest index mutual funds tracking
similar bogies didn't distribute a penny of
capital gains in 2018 (nor have some of them done
so in years), these funds were paying out
dollars' worth of gains. Outflows can wreak
havoc on index funds' tax efficiency.
The magnitude and timing of these funds' outflows
have been particularly problematic. During the
past three years, each of these funds' asset bases
has been more than halved by a shareholder
exodus. In the face of outflows of this magnitude,
there is little, if anything, portfolio managers can
PRIMARY MARKET
do to soften the blow as they realize gains to send
cash back to exiting shareholders. Their best
defense in this scenario is to first use any realized
losses they may have to offset gains. Once that
well has run dry, they canETFsell
those tax lots from
Shares
Provider
theirETF
portfolio
with the highest cost
basis and,
Securities
therefore, the greatest losses or lowest embedded
(In-Kind
gains. As is evidenced in the
sizeTransfer)
of the
distributions these funds issued in 2018, this is
small solace to taxable investors.
Hemorrhaging cash is one thing; hemorrhaging
cash in the middle of a bull market is another. The
timing of the withdrawals from these funds has
made the tax damage even worse. Years into
a market rally, funds have few realized losses left
to shield them, and the securities in their portfolios

Morningstar Winter 2019

Cash

have generally ticked up in tandem with
global
Capital
Fund Thus, net outflows from these portfolios
markets.
Markets
will almost inevitably result in capital gains. These
Securities
extreme examples illustrate that low turnover
alone isn't enough to explain ETFs' tax efficiency.
Structure Is a Built-In Advantage
From a tax perspective, ETFs' most significant edge
over mutual funds is rooted in their structure.
This structural advantage springs forth from the
in-kind creation-and-redemption mechanism
by which ETF shares are brought into and removed
from the market. The differences between
ETF
how ETF shares and mutual
fund shares are
Securities
Shares
created and destroyed have important implications
for investors in each wrapper.
The ordinary creation-and-redemption process
in a traditional mutual fund is straightforward, as
illustrated in EXHIB IT 2 . When investors want
to buy a fund, they fork over their cash to the fund
SECONDARY MARKET
company in exchange for shares; the portfolio
Buyer
manager then puts that money to work, buying
assets on behalf of the fund. Investors sell
their shares when they want their money back. If
there isn't cash on hand, the portfolio manager
Authorized
Stock
ETF Shares
Participant
Exchange
may have to liquidate
assets to raise cash
to hand back to the investor when it comes time
for the investor to sell.
This buying and selling, prompted by investors
Seller
regularly entering and leaving the fund, comes at a
cost. That cost has a few different components:
1 There is the frictional cost of portfolio turnover,

which comprises things like brokerage
commissions, bid-ask spreads, and market
impact-where trades move market prices away

meaningful part of this cost equation. As
funds liquidate securities to meet redemptions or
to free up cash to invest in new securities,
they will often realize sizable taxable capital gains,
which are passed on to shareholders.
These costs-which are created by investors
coming and going from the fund-are shared, or
socialized, across all investors in the mutual
fund, including long-term investors.
The creation-and-redemption mechanism for ETFs
is a completely different animal ( EXHIBIT 3 ).
The ETF market is split in two: a primary market for
ETF shares and a secondarySecurities
one. Virtually all
investors deal exclusively in the secondary
market,
(In-Kind Transfer)
ETF
back and forth between one
trading ETF shares Shares
another on an exchange.
When supply and demand for ETF shares gets out
of whack, actors from the primary market mobilize.
For example, if investors want more shares of
an ETF than are available (that is, demand outstrips
supply), that fund will trade at a premium to
its net asset value. This sends a signal to authorized
participants-a special breed of market makers-
to create new ETF shares. They do so by
gathering a basket of securities, like all the stocks
in the S&P 500, and handing those securities
over to the ETF provider in exchange for new
ETF shares. The authorized participant then sells
the shares on the secondary market, bringing
supply and demand back in line and collapsing
the premium.
This same process works in reverse when supply
outstrips demand. This in-kind creation-andredemption process is what keeps the price of ETF
shares so close to the value of the basket of
assets in their portfolios.

Morningstar - Winter 2019

Table of Contents for the Digital Edition of Morningstar - Winter 2019