The tax benefits of ETFs

Many investors may turn to exchange-traded funds (ETFs) for more transparency¹ or lower costs², but they may forget that these investments are also tax efficient³. The benefit of ETFs’ tax efficiency lies in how shares are created and redeemed based on demand in the marketplace. Generally, the ETF issuer creates and redeems ETF shares through an “in-kind” process involving large institutional investors and market makers called authorized participants (AP). The APs have an agreement with the ETF manager that allows them to create or redeem shares of the ETF in large blocks known as creation units,  typically consisting of 10,000, 20,000, 25,000, 50,000, 80,000, 100,000 or 150,000 shares.

The key to ETF creation and redemption is that it typically avoids the cash transactions used by mutual funds that may trigger capital gains distributions and the resultant tax bill for investors. Now, let’s dive into the basics of ETF creation and redemption. During the creation process when demand for the ETF exceeds supply, the AP delivers a basket of securities held in the ETF to the issuer in exchange for a creation unit. In a redemption, however, the process is reversed and the AP receives a basket of securities while the ETF manager takes back a creation unit. Putting it all together, ETF shares are designed to be quickly created or redeemed elastically without cash transactions to help meet supply and demand in the marketplace.

Since these transactions happen in shares (in-kind) and not in cash, there are typically no capital gains. What’s more, current tax law states that capital gains are not recognized at the time of the transaction and are thereby not considered a taxable sale. In practice, the ETF creation and redemption structure may create meaningfully different after-tax returns between an ETF and an index-tracking mutual fund — even if both track the same index.

With ETFs, capital gains and taxes are generally recognized only when investors sell their own shares. On the other hand, investors in mutual funds can see gains and taxes impacted by the selling activity of other shareholders in the fund. To summarize, investors can use the list below as a guide to common events and how they are treated within the ETF structure.

• Portfolio rebalancing: Typically handled in-kind with transactions and generally not taxable for the ETF and its shareholders. If the ETF must sell securities no longer in the index and buy additional securities, though, this may be a cash transaction and a taxable event for the ETF.
• Corporate events (stock splits, mergers and acquisitions): Typically handled in-kind but again, if the ETF must sell or buy securities for cash, there may be a taxable event for the ETF.
• Shareholder redemption: When APs redeem their shares, this is usually handled with "in-kind" transactions rather than cash, which helps prevent distributions and taxes for shareholders.