Tax efficiency is one of the key benefits of exchange traded funds, but most investors would probably be hard-pressed to explain the details of how stock ETFs pull off this advantage.

The answer has to do with how ETFs are traded between investors. Their tax efficiency is also related to how ETFs create and redeem shares, and how they differ from traditional mutual funds.

When investors buy an equity mutual fund, the portfolio manager puts the cash to work by buying company shares. Conversely, when the fund receives redemption requests from shareholders, the manager sells stock to raise the cash, which can trigger a capital gain distribution for all the shareholders remaining in the fund.

ETFs do things differently. Invesco PowerShares has a great overview of how ETFs achieve their tax efficiency.

Investors trade ETFs on an exchange in the secondary market like individual stocks.

“When one investor sells ETF shares and another investors buys them on the exchange, the underlying securities of the ETF don’t need to be sold in order to raise cash for the redemption,” Invesco PowerShares notes.

Furthermore, trading firms known as authorized participants or APs are responsible for working with the ETF manager to create and redeem large blocks of shares, called creation units. These exchanges are “in-kind” transactions that involve stock rather than cash.

These large creation units are created and redeemed based on demand for the ETF, and selling pressure. [Creation and Redemption Explained]

“An in-kind redemption process enables the fund manager to purge the lowest cost-basis stocks through stock transfers during the creation and redemption process,” according to Invesco PowerShares. “The result may be greater tax efficiency because shareholder activity and resulting portfolio turnover don’t affect the portfolio to the same extent as with mutual funds.”

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