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.

The American Century fund is a "good" fund, but it is more expensive, less tax efficient, less transparent and less flexible than GDX. Conversely, GDX is 20% less expensive, more tax efficient, more transparent and more flexible, allowing intraday liquidity.

GDX has outperformed since its May 2006 inception as well as in 2008 on a pretax, and of course, post-tax basis.

Is it any wonder that GDX, not even three years old, has $2.7 billion in assets, while American Century Global Gold has $700 million after being in existence for more than two decades? Is it any wonder the market has responded positively to GDX?

Markets do work. As former Citigroup Chairman Walter Wriston used to say, "Capital will flow to where it is best treated."

Clearly, GDX is better serving most investors.

The fact is the mutual fund's managers are accomplished professionals who really do care about their investors. But the issues are clear. They are up against some structural competitive forces, some of which are out of their control, that are reshaping the investment landscape in a huge way.

The competitive forces are shaping a massive paradigm shift in how money is managed and distributed in this country. GDX took in $1.6 billion in net new flows in 2008. Framed another way, GDX took in more in one year than American Century accumulated in BGEIX in 20 years.

This stunning statistic is symptomatic of these larger forces. Through November 2008, $197 billion had been redeemed from long-term mutual funds, which included stock, bond and hybrid mutual funds, while $133 billion had flowed into ETFs.

The paradigm shift is under way.

What's Ahead?

The tax-efficiency train is going to pick up steam. Irrespective of what the new administration does regarding tax policy, there is a demographic driver at play. Knowledgeable, thoughtful, veteran investors I talk to who are recently retired have repeatedly reiterated how important this whole notion of tax efficiency is going to be in future years.

Consider that the oldest of the baby boomers are approaching 63. The youngest of the baby boomers are going to hit 45 this year. After you hit 45, you tend to think about the world a little differently. Things like taxes mean a whole lot more to you at 45 then they did at 35. As baby boomers age, they are going to stimulate a lot more focus on the tax-efficiency issue.

There is certainly going to be more dislocation in the world of mutual funds. I especially see greater disruption among sector mutual funds. For example, we now live in a world where an investor can buy the Health Care Select Sector SPDR (NYSEArca: XLV) with an annual expense ratio of 0.23%.

So where does a "run of the mill" 1.35% ER health care fund fit in? They may be "sold," but who is going to buy that type of sector fund?

In this environment, it is not hard to imagine a large number of sector funds going the way of eight-track tape players.

We owe Ted Aronson a tip of the hat. Ted, you were right in 1999. You are right in 2009. However, what is different today is now there is an antidote to the "skewering" you discussed 10 years ago. With ETFs, investors have an opportunity to do their own "skewering" of tax inefficiency.

William Koehler is chief investment officer at ETF Portfolio Solutions. He welcomes comments and suggestions for future columns at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .