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.

Showing Page 1 of 2