Exchange traded funds (ETFs) are truly unique products with a number of advantages. One of the “pros” of ETFs is their tax efficiency, which is a direct result of how ETF shares are created and redeemed.

The basic creation and redemption process of ETF shares is practically the exact opposite of mutual fund shares, writes James E. McWhinney for Investopedia. (What are ETFs?) When investors in mutual funds make redemptions, shares held within the fund need to be sold in order to raise cash to meet that redemption, triggering a taxable event. This isn’t always the case with ETFs, though.

The creation process is as follows:

  • The creation process of an ETF begins with a prospective ETF manager, or sponsor, filing a plan with the Securities and Exchange Commission (SEC) to create an ETF.
  • Once approved, the sponsor forms an agreement with an authorized participant (AP) – market maker, specialist or large institutional investor – who is able to create or redeem ETF shares.
  • The authorized participant then borrows shares of stock and places them in a trust to form creation units of the ETF.
  • The trust provides shares of the ETF that represent legal claims on the shares held in the ETF. The transaction is an in-kind trade where securities are traded for securities, which means no tax implications, since there was no cash changing hands.
  • Finally, the AP receives the ETF shares, and the shares are then sold to the public as stocks in the open market.

The redemption process is as follows:

  • First off, investors may sell shares on the open market – the more common option for investors.
  • The second option is to hoard enough ETF shares to form a creation unit and then exchange the creation unit for an underlying security – the option more generally associated with institutional investors because of the large volume of shares required.
  • When investors redeem, the creation unit is no more and the securities are handed over to the redeemer. (What are capital gains?)

ETFs minimize tax liabilities by paying large redemptions with shares of stock and the shares with the lowest cost basis in the trust are given to the redeemer. The result is an increase in the cost basis of the ETFs overall holdings but a reduction in capital gains. The low turnover means that capital gains in ETFs are relatively rare as a result of the creation/redemption process. (ETFs and taxes).

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

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.