How active ETFs can help reduce a portfolio's tax liability

 

With year-end approaching, advisors may be reviewing portfolios for potential capital gains distributions and opportunities to apply tax-smart strategies in eligible accounts. Decisions made now—such as harvesting losses or realizing gains ahead of distributions—can meaningfully influence a client’s after-tax outcomes.

One way to enhance long-term tax efficiency is by reallocating assets into exchange-traded funds (ETFs), which are generally more tax-efficient than mutual funds. Actively managed ETFs, in particular, allow investors to pair those structural tax advantages with professional oversight, flexibility, and the potential for added return. With established managers like T. Rowe Price offering active ETFs, investors can combine the benefits of convenience, cost-effectiveness, and capital gains efficiency in a single vehicle—making them a timely tool for this year’s tax planning season.

Why consider using an active ETF as we approach year-end?

1. ETFs have been more tax-efficient

In terms of capital gains tax, ETFs have historically been a more tax-efficient vehicle than some other investment structures, such as mutual funds. The main reason ETFs have been more tax-efficient is due to the ETF’s unique create/redeem mechanism and the ability for ETFs to facilitate outflows in kind. Even though ETFs may still generate a capital gain distribution, shareholder activity of buying and selling shares doesn’t create taxable events for the funds, unlike in mutual funds.

Keep in mind, there are many factors that will impact the tax efficiency of an ETF and should always be taken into consideration (e.g., trading activity, issuer procedures, time in market). For investors who want the structural tax advantages of ETFs along with the benefits of active management—such as research-driven security selection, flexibility to adapt to markets, and risk management—active ETFs have the potential to add value to an investor’s portfolio.

“…active ETFs have the potential to add value to an investor’s portfolio.”

Figure 1 illustrates the percentage of all active and passive U.S.-listed mutual funds and ETFs that made capital gain distributions in each of the past five calendar years. It’s a myth to say that an ETF will never generate a capital gain. But structurally speaking, ETFs have done so at a much lower rate than mutual funds—even actively managed strategies. Some of T. Rowe Price’s Active Equity ETFs, for example, have distributed little (or in some cases, even zero) year-end capital gains over the past three years.

2. Active international ETF strategies have added alpha in 2025 

One area where the benefits of active management have been clear is in international equity markets, which have experienced a significant shift in 2025, driven by geopolitical dynamics and changes in U.S. policy. Non-U.S. markets (primarily Europe), emerging markets, and Japan, have outperformed U.S. markets, which were previously dominated by large-cap growth stocks. With a potential regime change away from U.S. exceptionalism, some global investors have actively sought new opportunities. Active managers are well positioned to help identify quality companies and regions that emerge from this shift. For example, the T. Rowe Price International Equity ETF (TOUS) has exceeded the returns of the MSCI EAFE Index Net by over 4%¹ over the last year (Figure 2).

3. Lower fees for an active approach

Just as active ETFs can add value through performance, they can also help reduce the overall cost of investing. When considering a move from mutual funds to ETFs, actively managed ETFs may also offer investors a way to reduce overall portfolio expenses in the process. Reduced expenses can help with the overall long-term outcome. ETF operational costs are often streamlined relative to active mutual funds with fewer shareholder services, client statement reporting, and other expenses. Well-established firms may have additional pricing advantages. By leveraging the global scope and scale of our firmwide resources, T. Rowe Price active ETFs are competitively priced relative to their peer groups. For example, illustrated in Figure 3 are some examples where T. Rowe Price active ETFs offer competitive fees relative to category averages.

Tax loss harvesting opportunities should be evaluated throughout the year

Beyond structural efficiency and lower expenses, advisors can apply active ETFs in tactical ways as well. One of the most important tools—especially in volatile years—is tax loss harvesting. This should be an ongoing, disciplined part of an advisor’s portfolio management process.

“One of the most important tools—especially in volatile years—is tax loss harvesting.”

The sharp market pullback in March and April of 2025—followed by a powerful rally to new all-time highs—was especially evident in the technology sector, where some of the largest ETFs in the category fell as much as 25% at the April lows. With ongoing uncertainty around tariffs, the ever-shifting landscape of true artificial intelligence beneficiaries, and intensifying competition from China, advisors had an opportunity to reposition into active strategies better equipped to navigate these headwinds.

An active technology ETF like the T. Rowe Price Technology ETF (TTEQ) not only offers the flexibility to adapt to changing market conditions but has also delivered strong results—outperforming many passive peers since the April lows (Figure 4).

Are there tax loss harvesting opportunities this year?

Given the market swings of 2025, it’s worth asking: Where do tax loss opportunities exist today? Categories for consideration will depend on an investor’s holding period and individual portfolio allocations, and investors should always consult their financial professional and tax advisor.

Year-to-date, there have been limited opportunities for tax loss harvesting. However, taking a trailing 12-month view, we see some potential areas to explore. For example, the municipal market has generally been performing well this year (Figure 5). Municipals provide federally tax-exempt income, and interest may be exempt from state and local taxes, making these vehicles attractive to investors who anticipate higher taxes in the future.

While short-term municipal ETF returns are positive, other categories, to include intermediate, long duration, and high yield municipal ETFs, show negative one-year trailing negative returns. Similarly, many municipal mutual funds have positive performance year-to-date but carry losses over the past year.

Since municipal funds are typically held in taxable accounts, harvesting those losses can be especially valuable to offset capital gains elsewhere in the portfolio. The T. Rowe Price Intermediate Municipal Income ETF (TAXE), an ETF that may hold up to 20% in high yield, could be a compelling option for advisors to diversify a portfolio, go active, and preserve exposure to tax-free income.

While it may be top of mind at year-end, tax considerations should be part of an ongoing portfolio review. Active ETFs offer many benefits, including tax efficiency, lower costs, and the potential to outperform the benchmark. While individual circumstances will vary, ETFs can be a useful tool for investors looking to reposition their portfolios.