Exchange traded funds are tax efficient because of the way the investment vehicle is structured to make “in-kind” transfers, or swapping underlying securities for ETF shares, instead of making cash trades. However, there are exceptions to the rule.
There are instances when passive managers will have to become active buyers or sellers of securities if they wish to access certain areas of the markets, reports Ari Weinberg for the Wall Street Journal.
For instance, the emerging markets may place restrictions on flows of securities as a way to to prevent shares from passing between different owners without a purchase and sale. Consequently, ETF managers would have to dip into the markets themselves to make the necessary trades.
ETF managers are also more likely to purchase assets in thinly traded fixed-income markets, such as municipal or high-yield corporate bonds, as these securities are used less for in-kind transactions. Additionally, managers will also take cash in bond markets where trading is tied to future delivery, such as in mortgage-backed securities.
Additionally, dividends and interest accrued would be used to add additional shares of the underlying securities.
Lastly, if an index rebalances or reconstitutes its holdings, ETFs will have to buy and sell securities to reflect the necessary changes. A debt downgrade or debt maturation would cause an index change for bond funds. In equity ETFs, corporate mergers and changing market conditions could affect an ETF’s holdings.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.