Passive, set-it-and-forget-it portfolio management often fails because investors don’t have the discipline and emotional where-with-all to stay invested when markets decline. They often miss out on the recoveries that can happen quickly after a market downturn. That’s why many choose active portfolio management, which responds to changes in the markets in real time.
The issue: Active portfolio management may realize gains throughout the year that could result in significant taxable events if active management takes place in taxable accounts. The taxes can significantly cut into the returns that are generated through sound active management.
This guide explains how you can introduce your clients to an active investment solution that limits the impact of taxes on their returns and provides greater flexibility when they pay them.
Active Portfolio Management: The Basics
Active portfolio management is a hands-on investment strategy where professional managers or individuals actively select, buy, and sell securities. The primary goal is to improve portfolio performance.
Unlike passive management, which takes more of a set-it-and-forget-it approach, active managers may rely on research, market forecasts, economic indicators, expertise, and other factors to seek to improve performance, taking advantage of opportunities in the markets while reducing risks. Active managers can use fundamental and technical analysis, as well as quantitative tools, to make informed investment decisions. They shift asset allocation, increase cash holdings, or use hedging techniques to seek to protect against downturns and enhance performance.
Tax Implications of Active Portfolio Management
Because of frequent buying and selling and other factors, actively managed portfolios come with significant tax obligations when held in taxable (non-retirement) investment accounts. The types of taxes include:
Capital gains taxes: Active managers frequently buy and sell securities to outperform the market, leading to higher turnover and more capital gains distributions which are taxed at capital gains tax rates.
- Income taxes: Frequent trading often produces short-term gains, which are taxed at higher ordinary income rates, rather than the more favorable long-term capital gains rates.
- Net investment income tax (NIIT): High-income investors may be subject to an additional 3.8 percent tax on net investment income.
- Annual tax liability: Even if an investor does not sell their shares in an active mutual fund, they may still owe taxes on the capital gains distributed by the fund annually.
This tax drag can negatively impact portfolio performance. If not handled properly, the tax burden can make the returns of an actively managed portfolio less appealing than a passive one.
How Exchange Traded Funds Can Help
The integration of active management into an exchange-traded fund (ETF) structure fundamentally changes the tax consequences for investors in taxable investment (typically non-retirement) accounts. As covered, traditional active management typically results in higher taxes due to frequent trading and portfolio turnover, which generates realized capital gains. This is true whether an investor is accessing active management through a separately managed account or through a mutual fund. However, the ETF wrapper can significantly limit the tax drag because of its unique structural mechanisms.
Actively managed ETFs are designed to be more tax-efficient than traditional actively managed portfolios and mutual funds.
ETFs primarily use “in-kind” transfers, which involve the direct exchange of underlying securities for ETF shares (or vice versa) between authorized participants and the fund. The purpose is to bypass cash transactions to maximize tax efficiency. This mechanism, often referred to as in-kind redemptions or in-kind creations, avoids the sale of securities and thereby prevents capital gains taxes. (It also reduces transaction costs, an added benefit.)
Some of the other ways ETFs help with the active management tax burden include:
- Tax-efficient holding: When you do sell, you are taxed at lower long-term capital gains rates (0 percent, 15 percent, or 20 percent depending on income) if held for more than a year.
- Deferred tax payment: You control when the tax event occurs (when you sell), rather than being forced to pay taxes on capital gains distributed annually by a fund, even if you did not sell shares.
According to Fidelity, in 2024, only 9 percent of active equity ETFs made capital gains distributions, while 64 percent of active mutual funds did.
ETFs, Active Management, and Taxes: The Bottom Line
Active ETFs allow financial professionals to introduce their clients to a solution that pairs professional oversight and enhanced investment performance with structural tax advantages because of in-kind trades. By comparison, other actively-managed strategies, including mutual funds, which must often sell securities for cash, trigger capital gains that are distributed to all remaining shareholders — even if the fund’s value declines in a given year. This results in a tax drag that limits returns.
In addition, ETFs allow investors greater flexibility in when they pay taxes on their holdings, typically when they are sold and not annually.
According to a July 2024 report by ISS Market Intelligence, more than 60 percent of financial advisors planned to increase their usage of ETFs. This includes over 50 percent who plan to do so with active ETFs. Don’t you owe it to yourself to learn about — and introduce your clients to — a leading actively-managed tax-efficient ETF solution? Click here to find out more.
About McElhenny Sheffield
McElhenny Sheffield believes that avoiding material losses is the foundation of successful long-term investing. Risk management and capital preservation are the firm’s top priorities.
The firm is committed to protecting investors’ financial futures through a proven rules-based, momentum-driven, trend-following tactical ETF strategy, and positioned as a tactical allocation for advisors who need to protect their clients’ core portfolio while still seeking growth.
Clients include independent-thinking investment advisors across the U.S., large investment allocators, and high-net-worth individuals and families looking for a second opinion. McElhenny Sheffield also provides sub-advisory services for RIAs and financial advisors. The firm was founded in Dallas, TX, in 2000, and as of March 31, 2026 manages more than $760 million in assets under management.