Picture two investors. Each puts $1,000,000 into an S&P 500 index fund at the end of 2015. Each holds for ten years and never sells a share. They own the same 500 companies, in the same weights, earning the same returns. One buys the index through an exchange-traded fund1. The other buys it through a mutual fund. Ten years later, after tax, they can be more than a million dollars apart.
Nothing about the index caused that gap. Both investors owned the same market. What separated them was the wrapper, the legal structure the index was delivered in, and the tax that one structure created along the way and the other did not.
1. The ETF used in this analysis is SPY (SPDR S&P 500 ETF Trust). It was chosen deliberately as the conservative case: SPY is a unit investment trust that cannot reinvest dividends internally, it pays its distributions several weeks after the ex-date, and at 0.0945% it is the most expensive of the major S&P 500 ETFs. A cheaper, structurally more flexible ETF such as IVV or VOO could be expected to show a wider, not narrower, after-tax advantage, although that comparison was not separately analyzed. Provided for context only; not a recommendation of any security.
A mutual fund and an ETF can hold the identical portfolio and still treat you very differently at tax time, because of how each one handles the buying and selling that happens around you.
When you own a mutual fund, you are pooled with every other shareholder. If enough of them sell, the fund has to raise cash by selling stock. Markets generally tend to rise over time, leaving many constituents of the mutual fund with an embedded capital gain that becomes realized during the sale of stock to meet shareholder redemptions. Under applicable tax laws, the fund is generally required to pass that gain through to the shareholders who stayed, as a taxable distribution at year end. So you can receive a capital gain, and a tax bill, in a year you did nothing at all, produced by decisions other investors made. Any rebalancing the fund does to incorporate changes to the index’s underlying constituents adds its own realized gains on top.
This is not unique to the funds in this study. Russell Investments, using Morningstar data, has tracked the average U.S. equity fund’s capital gain distribution every year since 2001, and the line has never once fallen to zero. On average, these funds handed shareholders a taxable gain in every single year, whether the market rose or fell. The clearest case is 2008: the market fell about 37%, one of the worst years on record, and the average U.S. equity fund still distributed roughly 8% of its value in taxable capital gains. A terrible year for the market was not a reprieve from the tax bill.
Average capital gain distribution of U.S. equity funds (right axis) versus Russell 3000 total return (left axis), by calendar year. Source: Russell Investments and Morningstar Direct, December 11, 2025; reproduced with attribution. Distribution line reflects actual averages through 2023.
An ETF is built differently. When large investors leave an ETF, the fund can hand them baskets of stock instead of cash, and it hands out its lowest-cost shares first. That single mechanism lets an ETF meet redemptions and rebalance without realizing much in the way of taxable gains2. The result shows up in the distribution record. Over the full ten years, the ETF in this study paid out zero capital gain distributions. Every mutual fund distributed gains, some of them large, year after year.
You can receive a capital gain, and a tax bill, in a year you did nothing at all, produced by decisions other investors made.
2. The mechanism reduces, but does not eliminate, taxable distributions. ETFs can and sometimes do distribute capital gains, and this treatment reflects current tax law, which could change.
To measure the cost, we ran the same $1,000,000 through five S&P 500 index vehicles over the ten years ended December 31, 2025: one ETF and four mutual funds. We reinvested every distribution and paid the tax on it out of the distribution itself, at top federal rates. Each pre-tax path was validated to reproduce that vehicle’s total return for the period.
These five were not selected at random, but they are not a single outlier chosen to prove a point either. The four mutual funds are all straightforward S&P 500 index funds from large, established financial institutions, widely available to individual investors, and each was included on the basis of availability and clean, verifiable data. This is an illustration built from ordinary, mainstream funds, not a statistical sample of the entire fund universe.
Before tax, the five were nearly indistinguishable. They finished within about four-tenths of a percentage point of each other, annualized, which is what you would expect from five funds tracking the same index. After tax, they scattered. The mutual funds gave up between 1.4 and 4.4 percentage points per year to tax, every year, compounded for a decade. On the original $1,000,000, the ETF ended at about $3.80 million after tax. The mutual funds ended between $2.63 and $3.44 million.
Same Strategy, Different Score. After-tax annualized return and ending value on a hypothetical $1,000,000, five S&P 500 index vehicles, 12/31/2015 to 12/31/2025, top federal bracket. Mutual funds shown anonymously as Complex A through D. Source: fund distribution and NAV data via Bloomberg; 1900 Wealth analysis. Hypothetical illustration; does not represent any actual account and is presented before deduction of 1900 Wealth advisory fees. See Important Disclosures.
The exact figures, before and after tax, and the tax paid along the way (hypothetical; before deduction of any advisory fees):
It is worth being precise about the cause, because there are only three things it could be: fees, performance, or tax.
One fund makes the point better than any argument, call it Complex C. Before tax, it was the closest thing to the ETF in the whole study. Over ten years it tracked to within roughly 13 basis points a year; a difference of about $46,000 on a $1,000,000 investment. If you only looked at pre-tax returns, you would have called it an acceptable index fund.
After tax, it finished $1.17 million behind the ETF. It paid $689,567 in tax over the decade, against the ETF’s $73,899, roughly nine times as much, to track the same index.
Here is the part that stops people. After paying all that tax and reinvesting what was left, Complex C ended the period with an unrealized loss. Its cost basis, $2.98 million, was higher than the $2.63 million the position was actually worth. The investor paid nearly seven hundred thousand dollars in tax and still ended up underwater on paper.
How does an index fund do that? By distributing enormous gains along the way. In some years Complex C paid out more than a fifth of its entire value in a single capital gain distribution. Every time, the investor owed tax, paid it, and reinvested the smaller amount that remained, at a higher cost basis every distribution. Ten years of that, and the basis climbed past the value of the fund. The index did its job. The wrapper undid a large part of it.
You can watch it happen. The chart below plots each vehicle’s after-tax value every trading day for ten years. In December 2023, a single distribution cost Complex C $104,238 in tax in one day, the notch visible in the inset. Over the entire decade, the largest single-day tax the ETF ever produced was $2,635.
What You Keep, Day by Day. After-tax value of a hypothetical $1,000,000 valued every trading day, five S&P 500 index vehicles, 12/31/2015 to 12/31/2025, top federal bracket. Inset shows one December indexed to 100: the mutual fund drops on the day the tax is paid. Source: fund distribution and NAV data via Bloomberg; 1900 Wealth analysis. Hypothetical illustration; see Important Disclosures.
Picture two investors. Each puts $1,000,000 into an S&P 500 index fund at the end of 2015… One buys the ETF the other buys a mutual fund…Ten years later, after tax, they can be more than a million dollars apart.
I want to be careful not to overstate the case, because part of the ETF’s advantage is timing, not a permanent saving.
This comparison is measured pre-liquidation, meaning no one sold at the end. That is realistic; long-term investors hold. But it also means the ETF investor is sitting on a large gain that has been deferred, not erased. The mutual fund investors paid tax as they went. The ETF investor was allowed to keep that money invested and compounding, and will owe tax on the gain whenever the position is finally sold.
So how much survives if the ETF investor sells everything and settles up? We taxed the entire remaining gain at the long-term rate. On that basis, the ETF keeps roughly 40% to 52% of its advantage across the four funds. Against Complex C, the $1.17 million edge becomes about $476,000 after a full liquidation. That last figure is an estimate, not a fact: it depends on selling the whole position at once and on the long-term rate in effect at the time.
That is still a large, durable number, and it is the honest one. Part of what the ETF delivered is a permanent tax saving, the distributions the mutual funds paid and it did not. The rest is the value of deferral, of keeping the government’s eventual share working for you in the meantime rather than paying it out in pieces every December. Both are real. They are not the same thing, and a careful analysis should separate them, which is what the figures above do.
None of this is about predicting the market or picking better funds. Every vehicle here owned the same index and earned essentially the same pre-tax return. The lesson is narrower and, I think, more useful. For a taxable investor, details and tax-consequences matter.
If your S&P 500 exposure sits in a tax-deferred account, an IRA or a 401(k), none of this applies; the distributions are not taxed as they happen, and the fund choice generally comes down to after-cost performance. But in a taxable account, the structure you hold the index in can quietly cost you more than a percentage point a year after tax, without changing a single thing about the underlying investment. That is a cost worth noticing, because unlike the market, it is one you can largely control.
This is the first piece in a short series on that idea, the next step goes further than the exchange traded wrapper. It looks at owning the index directly so that you can do something a fund cannot, and you can potentially harvest the ordinary ups and downs of individual stocks into tax advantages (above and beyond those typically seen with ETFs) all while the index rises3.
3. This approach carries its own costs, risks, fees, and limitations. We will explore this topic in a later installment of Monthly Market Observations.
Put it together. Two investors, the same S&P 500 index, ten years, no trading. The one who held it in an ETF kept far more after tax than the one who held it in a mutual fund, not because of skill or luck or lower fees, but because one structure handed out taxable gains along the way and the other did not. Tax explained the overwhelming majority of the difference. Some of the ETF’s edge is a permanent saving and some is deferral, but even the conservative, sell-it-all measure leaves a large gap.
The market gives every S&P 500 investor the same return. What you keep after tax depends, more than most people realize, on the wrapper you choose. In a taxable account, it is worth choosing on purpose.
If you are not sure how your own accounts are positioned, that is exactly the conversation to have with your advisor. That is what we are here for.
We invested a hypothetical $1,000,000 in each vehicle at its December 31, 2015 price and held to December 31, 2025. Every distribution was reinvested at the ex-date price, with the tax paid out of the distribution and only the remainder reinvested, the consistent with the SEC’s standardized pre-liquidation after-tax return methodology. We applied top federal marginal rates including the 3.8% net investment income tax: 23.8% on qualified dividends and long-term capital gains in every year, and 43.4% (2016 to 2017) or 40.8% (2018 to 2025) on short-term capital gain distributions, which are taxed as ordinary income. We assumed no state income tax, consistent with a Texas-resident investor; results for investors subject to state or local income tax may differ.
Two items are assumptions, not facts, and are disclosed as such: all income distributions are treated as 100% qualified, because the source data carries no qualified-versus-nonqualified split, and the net investment income tax is assumed to apply. The post-liquidation figures are an estimate that taxes the entire terminal gain at the long-term rate.
Each pre-tax path was validated to reproduce the vehicle’s Bloomberg total return for the period to within about half a basis point, with no calibration or adjustment of any kind. Complex C’s distributions and year-end values were additionally tied to its audited annual report. Fund distribution and net asset value data and ETF prices were supplied from Bloomberg and treated as governing; SEC filings and brokerage availability were used to confirm that each share class is open to taxable investors. Analysis by 1900 Wealth.
This material is provided by 1900 Wealth Management, LLC for informational and educational purposes only and represents the views and opinions of the author as of the date of publication. It does not constitute investment, legal, or tax advice, nor an offer or solicitation to buy or sell any security or to adopt any investment strategy, and it is not a recommendation of any security, fund, or fund structure. The analysis presented is a hypothetical illustration based on historical data. It does not represent the actual results of any client account or any real investor, and hypothetical results have inherent limitations. Hypothetical performance is prepared with the benefit of hindsight, does not reflect actual trading in any account, and cannot fully account for factors, including the risk of loss, that would affect an actual portfolio; no representation is made that any account will or is likely to achieve results similar to those shown. The outcomes depend on specific assumptions, including a top-bracket taxable investor, no state income tax, reinvestment of all distributions, income treated as fully qualified, and the tax rates in effect during 2016 to 2025; different assumptions, tax situations, holding periods, or time frames would produce different results, and actual results would be reduced by 1900 Wealth’s advisory fees and other account-level expenses, which are not reflected here and which, compounded over time, would materially reduce the results shown. Mutual funds are shown anonymously; the specific vehicle behind each figure is identified in 1900 Wealth’s working files. Fund distribution and net asset value data, and ETF price data, were supplied from Bloomberg and treated as governing; results were validated against Bloomberg period total returns and, where available, audited fund reports. Past performance is not indicative of, and does not guarantee, future results. ETFs are not immune from making capital gain distributions, and the tax treatment of ETF in-kind redemptions described here reflects current law, which is subject to change. This material is intended for clients and prospective clients of 1900 Wealth for whom the assumptions described are relevant, and is not intended for general public distribution. All investing involves risk, including the possible loss of principal. Tax laws are complex and subject to change; please consult your own tax advisor regarding your circumstances, and consult your 1900 Wealth advisor before making any investment decision.
For informational purposes only. Not investment advice. See disclosures.
Bobby serves as Chief Investment Officer at 1900 Wealth Management, where he manages a team of investment officers and oversees portfolio strategies for clients. He also develops new business relationships and contributes to firm growth.
A Chartered Financial Analyst (CFA), Bobby previously analyzed fixed-income investments for USAA and its related funds. His career spans capital management, private equity, and financial operations in multiple industries.
Bobby holds a Bachelor of Business Administration in Accounting and Finance from Texas Christian University.
