Exchange traded funds (ETFs) are touted for their tax efficiency. In fact, it’s one of the major selling points for the funds.

Ian Salisbury for The Wall Street Journal explains that the rapid growth taking place within the ETF industry along with the increasing complexity of some funds, is making the goal of tax-friendliness harder to reach. Now that 2007 is finished, it is easier to get a good picture.

Last year, 95 ETFs, or 18% of ETFs tracked by Morningstar, passed along capital gains distributions to investors. In 2006, it was merely 6%, and 2005 presented only 3% of ETFs with capital gains taxes. The waning "tax efficiency" is a byproduct of the explosive popularity if ETFs.

The dynamic involves the newer funds that are traded too thinly, thus making it more difficult for managers to maneuver holdings in order to keep from realizing gains. Many of the newer funds are such a narrow slice of the market that they are more volatile, which leads to big gains and losses, and the gains equal distributions.

However, ETF capital gains taxes are minor when compared to actively managed mutual funds, some of which amounted to 10% or more of fund assets in 2007.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.