Why the ETF Structure May be More Tax Efficient for the American Investors.

Exchange-traded funds (ETF) in the United States have some tax advantages compared to the unit trust in the United States. This means that it may be more efficient for an American investor to invest through an ETF structure than a unit trust structure.

It has become more popular for existing unit trust to attach an ETF to the fund.

This is something that some investors may not be aware about.

Jason Zweig over at the Wall Street Journal have a good piece about this called Your Mutual Fund Stinks. Can This Wall Street Invention Change That?

I would like to note down some of these differences for work purposes in case I forget where to find them again.

The Challenge for an Investment In a Unit Trust Structure.

When an investor sells a share of a unit trust, the fund cashes the person out, typically from the cash reserves in the fund.

If too many investors of the fund sell at once, the unit trust may have to sell some of the underlying securities.

Selling the securities can:

1. Create a domino reflexivity effect.
2. Is tax inefficient for the investors.

How the ETF Structure Helps

ETFs trade on the secondary market and do not directly sell the securities so they are not so susceptible to the domino effect.

Gus Sauter, Vanguard’s former CIO, co-developed the idea of ETFs as a share class alongside their unit trust and patented it in 2005 (patent expired last year).

His idea is to protect the unit trust’s long term investors from the short term investors of the unit trust.

In an ETF structure, Vanguard won’t be stuck trying to trade billions of dollars on a crash day. Short-term capital gains are taxed in the investors ordinary income tax, which can be higher than long-term capital gains (typically lower).

Trading cost is also lowered significantly.

ETF Structure Doesn’t Prevent All Tax Inefficiency

Gus Sauter notes that if there are massive redemptions from an underperforming actively-managed unit trust in an up market could saddle the investors in the ETF share class with capital-gains liabilities.

Since unit trust that adds ad ETF as a share class would have to disclose their holdings daily, this may create a potential for predatory traders to front-run their transactions.

Tax Efficiency May Not be the Only Reason More and More Unit Trust Create ETF Share Class

I think that ETFs are more popular because of the story behind ETFs.

Some investors assume all of them are more sound, more cheap and investors are selling their unit trust to invest in ETFs.

Hell, I have investors who are still at a dinosaur age thinking all unit trust are more expensive than the ETFs locally in Singapore.

The big name managers has a monetary incentive to shift over because they are losing their clients.

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