How do actively managed ETFs work?
ETFs may deliver a more tax-efficient experience than mutual funds due to differences in how shares are created and – more importantly – redeemed. When an investor wants to redeem shares of a mutual fund, the fund company sells securities to raise cash, and realized net gains are passed on to remaining fund investors as taxable distributions.
In contrast, many ETFs can be redeemed in-kind, through authorized participants (APs). This means that, instead of the fund provider having to sell securities to raise cash, it can exchange shares of the ETF for shares of the underlying securities. Critically, these in-kind transfers between APs and ETF issuers are not taxable events for ETF investors.
While ETFs tend to be a more tax-efficient wrapper than mutual funds, the underlying assets and strategy matter too. Fixed income, as an example, tends to generate a lot of its returns from generating income that is distributed each year and taxed at ordinary income rates regardless of holding period. Holding bonds in an ETF wrapper doesn’t make them much more tax-efficient. Active equities is one area in particular where the ETF wrapper can make a difference, since reducing capital gains distributions can have a large impact on the strategy’s ability to compound returns over time.
Building active ETFs into your portfolio construction process
Tax efficiency is just one element in determining where to look for alpha with active ETFs. Consider three big questions first:
- Are there opportunities to generate alpha within the manager’s target market?
- Does the manager have a track record of delivering alpha in that space?
- Do you, the investor, have a track record of picking and holding onto good manager?