Compared with regular (“open-ended”) mutual funds, exchange-traded funds (ETFs) are extremely tax-efficient because they rarely make capital gains distributions to investors. Why are ETFs so tax-efficient?
Few redemptions. When ETF investors decide to sell their shares, they sell to other investors, not back to the fund. Thus, ETFs do not have to raise cash to redeem outstanding shares.
By contrast, mutual fund investors deal with the fund itself. When there is a rash of redemptions, the fund will have to raise the cash-often by selling securities. If those sales generate gains, the gains are passed through to shareholders, pro rata.
Indexing. Most ETFs are index funds, designed to track a certain stock market index. In some cases, an ETF will track an index of foreign stocks or stocks in a particular market sector Because they’re index funds, ETFs generally have low turnover, with little active trading, so they seldom realize capital gains. If there are few realized capital gains, there’s not much to distribute to investors.
No sale. When ETFs must revise their holdings, they do not sell the securities they hold. Instead, they transfer large blocks of shares among arbitragers, specialists, and market makers. The tax code states that such “in-kind redemptions” do not generate taxable gains to a fund, even if the securities transferred by the fund have appreciated in value.