ETFs and Tax Efficiency | ETF Trends

Exchange traded funds have been lauded for their ease of use and tax efficiency. Nevertheless, the tax season is creeping up and ETF investors should still be mindful of what to expect.

ETFs are regulated under the Investment Company Act of 1940, which makes them structurally similar to index funds that buy and hold components of a market benchmark, but they are traded on an exchange like stocks, writes Ari I. Weinberg for The Wall Street Journal.

ETFs offer protection from capital gains events when individuals leave or enter positions in an ETF investment. Securities transaction costs for the funds themselves are also lower because the cost of trading is only subject to the individual investor. [ETFs and Taxes]

ETFs allow investors to be “isolated from the actions of other investors,” Ryan Issakainen, ETF strategist for sponsor First Trust Advisors LP, said in the report. [ETFs and Taxes: What You Need to Know]

Shares of ETFs are created or redeemed in “in-kind” transactions with large institutional traders. Market makers, or authorized participants, swap a bundle of underlying securities to the fund manager to create an ETF share, or redeem an ETF share for a bundle of securities. No cash is being exchanged and the in-kind transaction does not force an ETF to take gains.

A fund may also make an open market sale of a component holding if the stock falls below a certain point, taking on a capital loss. If a component is overperforming, the fund may swap the stock out through an in-kind redemption, which would remove any potential capital-gains tax hits. It should be noted that most ETFs have relatively low turnover.