Why ETFs in US are preferred over mutual funds: Nithin Kamath explains

Exchange-traded funds (ETFs) have gained popularity in the US, often being favoured over mutual funds, Zerodha’s founder and CEO Nithin Kamath posted on social media platform X.

US mutual funds operate as pass-through vehicles, which means that if the fund generates capital gains, these gains must be distributed to unit holders who pay taxes on these gains. This makes mutual funds less tax-efficient.

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In a post on social media Kamath wrote, “Something I learned recently on why ETFs in the US are preferred over MFs. US mutual funds are pass-through vehicles — if they generate capital gains, these must be distributed to unit holders who pay the taxes on the gains, which make MFs less tax-efficient.”


ETFs, on the other hand, avoid this issue through an ‘in-kind’ creation and redemption process. This structure effectively washes away capital gains, providing a significant tax advantage to ETF investors.

Given the tax inefficiency of mutual funds, many US investors opt for ETFs, especially index-based ones. This is the reason for the popularity of index funds, especially ETFs in the US market.

In India, mutual funds and ETFs do not pass on tax liabilities to unit holders. However, products like Portfolio Management Services (PMS) and Category III Alternative Investment Funds (AIFs) do pass on tax liabilities, making them less efficient from a taxation standpoint.

“ETFs avoid this through ‘in-kind’ creation/redemption that washes away gains. This tax advantage is significant. This is one underrated reason for the popularity of index funds, especially ETFs in the US. In India, both MFs and ETFs don't pass taxes to unit holders, while PMS and Cat 3 AIFs do,” Kamath posted.

While ETFs in the US have a clear tax advantage over mutual funds, the same does not hold in India. For Indian investors, choosing between mutual funds and ETFs, depend more on factors like expense ratios, liquidity, and investment objectives rather than tax efficiency.

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According to an image shared by Zerodha’s founder and CEO in his social media post, after overtaking active funds assets for the first time ever in 2023, the passive funds have extended their market share advantage in 2024. Around 53% of assets in the long-term open-ended funds and ETFs are now in indexed strategies and there is little evidence that this trend will revert.