Vehicle structure, strategy and asset class impact after tax returns

The bottom line

Choosing the right investment vehicle is like choosing the right car – it can be overwhelming. But investors can follow some simple guidelines to help increase the after-tax return of their portfolios:

• Investment vehicle structure, asset class & strategy are key drivers of relative tax efficiency when comparing ETFs versus Mutual Funds.
• ETFs have historically been more tax-efficient than Mutual Funds, regardless of asset class or strategy.
• Active ETFs may provide the opportunity for investors focused on both alpha opportunities and greater tax efficiency relative to mutual funds.
• Placing less tax-aware investments like Mutual Funds and taxable bonds in tax-advantaged accounts may help guard returns from tax drag.

Advisors can use these after-tax investing guidelines to help their clients keep more of what they earn. Earning “tax alpha” for clients also provides an incredible opportunity for advisors to set their practice apart. Keep in mind, advisors should always consider clients' overall portfolio goals and unique tax situations.

What drives fund tax efficiency?

What’s the best car? Well, it depends – do you care more about speed or safety? What terrain will you drive on? What’s your budget? Like this question, the answer to “what’s the best investment vehicle?” also depends. Are you looking for a low-cost, highly tax-aware exposure? Outperformance? Something in between?

The answers to both these questions have also evolved with time as new technologies and styles emerged. Flash back to 2000: only 6.7% of the world was online, and there were only a handful of ETFs.^1,2 Fast forward to 2025, when global electric vehicle sales reached 20.7 million, up 20% from the year before, and the ETF universe had grown to nearly 5,000 funds.^3,4

ETF popularity soared over the last two decades thanks to the innovative benefits they deliver including their low cost, competitive performance, and greater tax efficiency relative to mutual funds. Whether looking for active or index solutions, the ETF wrapper has historically offered more tax advantages.⁵ Active ETFs have continued to garner investor attention, surpassing $1.5 trillion in assets under management, and historically have been more tax efficient than both index mutual funds and active mutual funds.⁶

Percentage (%) of funds that paid cap gains & average cap gain size (%) over the last 5 years

Three drivers of after-tax returns: structure, asset class & strategy

What drives the degree of tax efficiency when comparing funds? It typically comes down to three things: 1) vehicle structure, 2) asset class, and 3) strategy.

1) Structure: What car make or model do you want? Differences in ETF and Mutual Fund vehicle structures lead to varying tax outcomes. For Mutual Funds, investors purchase and redeem shares directly with the fund manager. Redemptions from the fund may force managers to sell holdings at a gain, which could cause a taxable event for all investors.

In contrast, investors buy and sell ETFs on an exchange, and the creation and redemption of ETF shares are often done “in-kind” with third party Authorized Participants. The ETF creation and redemption process usually does not trigger a taxable event, allowing holders of ETFs more control over the timing of when they realize capital gains.

ETFs vs. Mutual Funds mechanics

Just as electric vehicles are revolutionizing the car industry, Active ETFs may be disrupting the fund industry by bridging the ETF wrapper’s potential tax advantages with the similar alpha potential of Active Mutual Funds. Investors are catching onto this attractive combination.⁷

Active ETFs set a record pace in 2025, bringing total AUM to ~$1.5T today (11% of total U.S. ETF market).

2) Asset class: Do you want a sedan, SUV or truck? Regardless of wrapper, investors shouldn’t forget the role that asset class plays in tax efficiency. Asset classes with returns primarily delivered as ordinary income tend to be less tax-efficient than those with returns primarily subject to lower tax rates such as capital gains (if held for more than a year), qualified dividend income, or tax-exempt income.

Tax treatment of distribution from different asset classes

Savvy investors select asset classes based on overall portfolio objectives while also considering the tax implications of returns. The chart below shows that taxable bonds had a similar 5-year tax cost to equity categories, but with a meaningfully lower pre-tax return. Because taxable bonds have historically had a lower return profile than equities and derive more of their return from income, tax drag can have an outsized impact on after-tax outcomes for bond investors.

5-year Tax Cost (%) across asset classes

Regardless of asset class, we still see below that ETFs on average have historically distributed fewer capital gains than Mutual Funds. This holds true for both index and active strategies.

Percentage of funds distributing capital gains by asset class over the last 5 years

3) Strategy: How fast do you want the car to go? Is 0 to 60mph, or 60 to 0mph more important? Velocity of investments can also matter when comparing after tax returns. Strategies that involve frequent trading to seek alpha may be less tax-efficient compared to strategies that track an index.

Over the past five years, both Mutual Funds and ETFs show a positive relationship between higher turnover and larger capital gains distributions, particularly for those with exposure to equities. However, the ETF structure helps limit taxable events when holdings change. This could explain why both Index and Active ETFs have historically distributed lower capital gains than Mutual Funds with similar turnover.

5-year Turnover Ratios vs. average capital gains for Equity funds (%)

Vehicle location matters, too.

Where will you park your car? While an all-terrain truck can handle rough weather outside, a protected garage is better for a new sports car. Likewise, sophisticated investors understand the significance of asset location. Investors can manage taxes by parking low-cost Index ETFs in taxable accounts, while parking Active Mutual Funds in tax-advantaged accounts to aim to protect alpha from tax drag. Taking a holistic portfolio approach across accounts can help maximize after-tax returns.