This allows the authorized participant to shoulder the impact of capital gains taxes. As mentioned, a mutual fund that must sell stocks in order to cover redemptions. This creates a scenario where the fund pays capital gains taxes that are passed on to the investor.

Certain ETF products could be subject to capital gains taxes, such as actively-managed funds. For these funds, a higher degree of buying or selling could result in more capital gains taxes incurred.

Still, most ETFs sell holdings only when the factors affecting their underlying index change. This results in a lower turn over ratio that creates taxable events.

Per Investopedia, some actively-managed mutual funds have a turnover rate of 100 percent. In contrast, the majority of ETFs have a turnover rate that is less than 10 percent.

Lack of Phantom Gains

Phantom gains consist of capital gains that an investor owes taxes even if the actual return realized on the investment results in a negative return. In the world of mutual funds, phantom gains can occur when an investor purchases shares of a mutual fund before a fund manager sells a large portion of holdings.

The fund manager’s sale of the holdings creates a taxable event. As such, any capital gains realized on the sale are then passed on to mutual fund investors.

Because of the way ETFs are structured, they do not expose themselves to these phantom gains. Securities within an ETF portfolio are exchanged and created through an in-kind exchange.

This results in the securities returned on a low-cost basis and received at a higher cost basis, which limits tax liability. This results in lower capital gains taxes as opposed to a mutual fund engaging in a similar transaction.

For more educational information on ETFs, click here for Education Central.