With the markets reaching new all-time highs, many investors will see their mutual funds distribute large capital gains during this holiday season. This is especially true in the mid- and small-capitalization segments of the market, given the generally strong returns this year and based on initial capital gains releases that I have been monitoring from some of the largest mutual fund companies.

Tax efficiency is one of the prime benefits of exchange-traded funds (ETFs), and I expect this tax reporting season to accentuate the benefits of the ETF structure.

Let’s explore why I believe ETFs manage taxes in a more efficient manner and why I expect little capital gains from the traditional U.S. equity-related ETFs.

There are a few reasons why mutual funds distribute large capital gains when investing in U.S. equities:

1) Portfolio Turnover: Their active nature involves portfolio turnover, and when there is turnover and trading, capital gains experienced inside the fund must be distributed to the fund’s shareholders. With the markets at new highs, capital losses that might have built up seem to be getting taken away and more capital gains are being realized.

2) Outflows from Funds: If investors rebalance their portfolios and on a net basis sell their shares in a mutual fund, the portfolio manager must sell securities to meet these cash outflows from the fund, which generates a taxable event for the remaining shareholders in the fund, even if they choose to maintain their investment. With the markets high, this fund outflow can trigger capital gains.

ETFs’ Creation/Redemption Process Helps Manage Realization of Capital Gains Taxes

The creation and redemption process for creating new shares and redeeming shares of an ETF provides more tools to manage capital gains, even those experienced inside the fund itself.

In-Kind Transfer Is the Key: The creation and redemption process involves an in-kind transfer of securities into and out of the fund.

The ETF’s underlying constituents are delivered into the ETF in exchange for newly issued shares of the ETF during the creation process. When shares are redeemed, the underlying components are delivered from the ETF portfolio to the authorized participant in exchange for ETF shares that are no longer considered shares outstanding. Neither of these transactions is considered a trade for tax purposes.

This in-kind transfer of securities is the mechanism that helps make ETFs such tax-efficient vehicles. It becomes something of a rare event for a security to be sold within a fund, as most sales are handled through this redemption process. The exception will be portfolio adjustments that need to be made for corporate actions or other extraneous portfolio activity.

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