Are capital gains eating away at your investments? Exchange traded funds (ETFs) are one of the most tax-efficient investment tools in a passive equity index.

Advisors know that maximizing returns in passive investment portfolios is through the management of capital distributions, writes Scott Burns for Morningstar. ETFs are one tool that usually come with low capital gains distributions and provide tax efficiency.

In a recent study comparing ETFs to open-ended index funds, the main competitor of ETFs, capital gains distributions for equity-based ETFs in 27 broad-based indexes were systematically arranged in 5-,10- and 15-year periods and then compared to open-end index funds that tracked the same benchmarks. What did the study find?

• Of the 27 ETFs, only two ETFs made capital gains distributions in the last give years and only one ETF did so in the last 10 years
• Of the 27 open-end groups, 25 made taxable distributions within the first five years and some small-caps had distributions larger than 5% of the fund’s net asset value

These results aren’t especially surprising, since ETFs were created with an innate arbitrage attribute that makes the funds tax efficient.

Taking a broader view of the entire ETF and ETN market, though, there are still some tax situations investors need to be aware of.  Of the roughly 850 ETFs and ETNs currently available, there are different tax implications in using ETF products that deal with derivatives, mostly leveraged, inverse and commodity-type ETFs. ETFs are “looked through” to their holdings and an investor would be taxed appropriately. Read our article on how these ETFs are taxed.

Our friends at Morningstar have also recently spruced up their ETF section. They’ve added new features, so be sure to check them out.

Max Chen contributed to this article.

Tags: ETF 101, Mutual Funds, Taxes