One of the first money managers I interviewed while serving as the director of research at a large pension consultant some 20 years ago was Ted Aronson, founder of Philadelphia-based Aronson+Johnson+Ortiz Partners.

I conducted more than 2,000 interviews from 1989 to 1996, and to this day, Ted remains one of the brightest, most thoughtful and candid managers I ever interviewed. Without a doubt, he's one of the people I most respect in the investment management profession.

Calling ‘Em Like He Saw ‘Em

In January 1999, I read an interview Ted did with Jason Zweig in Money magazine. Typical of Ted, he didn't pull any punches. As he has to this day, he called ‘em like he saw ‘em.

I have kept that interview all these years. A number of his observations were spot on, including his call that the performance of the stock market for the ensuing 10 years from those elevated valuation levels was going to be flat at best.

But I clearly remember one compelling quote he made regarding active management and taxes toward the end of the interview.

Zweig: "You're an active manager who has nearly all of his money in index funds?"

Aronson: "Once you throw in taxes, it just skewers the argument for active management. Personally, I think indexing wins hands down. After tax, active management just can't win."

I have never forgotten that particular quote. Sadly, the mutual fund industry did not pay it as much heed. I believe the industry has largely been indifferent toward the issue of tax efficiency.

The vast majority of portfolio managers are not incented to care about the taxable distributions their funds generate. This indifference is manifested in what can be called an annual ‘April Surprise' for investors.

That's when people call their accountants and say something like, "I owe an extra $11,000 in taxes on my mutual funds. But I never sold them and they are down. Is that right?"

Yes, Mr. Investor, that's right, and that's one reason so many more of you are moving to ETFs.

ETFs To The Rescue

In the subsequent 10 years, tax bills have ranged from benign to exceedingly onerous. It looks like 2008 will turn out to be better than the tax trap of 2007. But the problem remains. New solutions are around in abundant supply, however-unlike in 1999.

The growth of ETFs in the past several years offers a multitude of new options in providing welcome relief and solutions to the tax-inefficiency problem. Like costs and asset allocation, taxes are a factor that can be controlled by investors. ETFs now help this happen.

The tax issues of some of the leveraged and inverse ETFs we saw at the end of 2008 notwithstanding, traditional long ETFs are going to continue to provide a real tangible solution to this issue of tax inefficiency. I'm convinced one of the reasons the ETF revolution is upon us is tax efficiency.

A Microcosm Of The Issue

Let's compare the Market Vectors Gold Miners ETF (NYSEArca: GDX) with the American Century Global Gold Investor Class mutual fund (BGEIX) from a prospective investor's perspective. Here are the facts as of January 1, 2009:

In looking inside these two portfolios, their holdings are similar. The top 10 holdings comprise more than 60% of each portfolio. Eight of the top 10 holdings are identical. Both portfolios are driven by their heavy concentrations in Goldcorp, Barrick, Newmont, Kinross and other gold stocks such as Agnico-Eagle.

However, the similarities end there. GDX has never paid a taxable distribution, whereas BGEIX paid a $1.94-per-share distribution this past year (on Dec. 16). At a reinvestment price of $13.62 per share, it amounted to 14.4% of the mutual fund's net asset value.

I can guarantee you, this April there will be more than a few surprised owners of the fund who will question their accountant's mathematical accuracy. "You mean my $150,000 is down to $110,000 and I still have to cough up $2,400 more in federal taxes?" Yes, Mr. Investor, I'm afraid it's true.

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