“ETFs are also generally more tax efficient than mutual funds as a result of how new ETF shares are created and redeemed,” Rosenbluth added. “When an individual investor wants to sell an ETF, he or she simply sells it to another investor similar to a stock on an exchange. An authorized participant (AP) or broker dealer redeems shares of an ETF when there are more sellers than buyers, though as we saw last week they may wait a short period of time for improved pricing clarity. Such delays can cause notable discounts or premiums to NAV to materialize.”
Due to the structure of ETFs, baskets of underlying securities and ETF shares are created or redeemed through “in-kind” transactions, so the securities are never swapped for cash, which would trigger a taxable event. In contrast, mutual funds would have to sell securities to raise cash, which would trigger a taxable event for all shareholders. [ETFs & Mutual Funds: Lump of Capital Gains in Your Stockings]
However, not all ETFs are immune to capital gains.For instance, popular currency hedged international equity ETFs incurred sizable capital gains in 2014. These types of ETFs utilize currency derivatives that are rolled forward each month, and unlike stocks, derivatives are no treated “in kind.” So, with the USD appreciating, currency hedged ETF investors may see capital gains at the end of the year. Currency forward contracts are treated as 40% short-term and 60% long-term. [Why Some ETFs Can Issue Capital Gains Distributions]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.