ETFs’ more tax efficient nature is attributed to the innate “in-kind” creation and redemption process where baskets of underlying securities are exchanged in-kind for ETF shares, which does not trigger a taxable event. Moreover, most are passive in nature so they have less turnover than their mutual fund cousins.
In contrast, with a mutual fund, a capital gain event is triggered when a fund investor wants to cash out their position and the fund issuer will have to sell stocks to satisfy a redemption request.
Realized capital gains, by definition, occur when a fund’s holdings that have appreciated in value are sold. Consequently, funds with higher turnover – the amount of new securities purchased or the amount of securities sold – have a greater chance for realizing capital gains when funds rebalance their holdings, especially if there are no redemptions.
“The in-kind redemption structure of ETFs can make them a more tax-efficient vehicle, but remember: They aren’t immune to distributing gains,” Sotiroff said. “This year, many funds that were born into a bull market, have seen generally positive flows, and are underpinned by high-turnover indexes have featured prominently on the list of those distributing capital gains. Fixed-income funds have also been regulars on this roster.”
ETF investors who want to limit or avoid exposure to capital gains distributions can improve their portfolios by sticking to funds that are more mature and have experienced a decent mix of market conditions, eschewing those that use derivatives and staying away from funds with high turnovers.
For more information on ETFs, visit our ETF 101 category.