Tax Efficiency: A Key Benefit

Relative to many other investment vehicles, ETFs generally offer lower costs, intraday trading liquidity, greater portfolio transparency, and the potential for increased tax efficiency. The ability to avoid realizing and distributing capital gains is an important benefit that can positively impact ETF performance and help investors maximize their after-tax returns in nonqualified accounts.  

Low Turnover: A Key Advantage

Passive and systematic ETFs typically have lower portfolio turnover relative to other investment vehicles. And while actively managed ETFs are growing in popularity, most ETFs are currently passive and track indices that dictate when securities are bought and sold. ETFs also benefit from the fact that their shares trade in the secondary market where investors can buy and sell shares; this helps minimize the need to create or redeem ETF shares in the primary market, which would increase turnover.

In-Kind Redemptions: The Primary Advantage

ETFs’ main potential tax advantage comes from their inherent creation/redemption mechanism, which is much different from how other investment vehicles satisfy redemptions. For example, mutual funds often need to sell securities to raise cash for shareholder redemptions; this can increase the number of taxable events and likelihood of realizing capital gains. When capital gains are incurred, they’re distributed to all remaining shareholders.

By contrast, most ETFs often satisfy redemptions by delivering securities out of their portfolios via in-kind transfers. Because they aren’t deemed to be purchase-and-sale transactions, in-kind transfers don’t have any capital gains tax consequences for the ETF. ETFs can construct in-kind redemption baskets to deliver their appreciated securities and effectively defer any taxable gains for all remaining shareholders until they sell their own shares. There are, however, some limitations on what types of securities can be delivered in-kind and, subsequently, the need to include cash in the basket could decrease the tax efficiency of certain types of ETFs.

Because of in-kind transfers, one ETF shareholder’s decision to sell typically doesn’t impact other ETF shareholders. In addition, during an in-kind redemption, securities in the basket with the lowest-cost lots are removed. This has the effect of increasing the cost basis of the remaining securities, which helps to reduce their embedded, unrealized gains.

ETFs Aren’t Immune From Capital Gains

ETFs aren’t entirely tax efficient. Investors still need to pay taxes on any dividends or interest income in nonqualified accounts. In addition, ETFs that primarily use cash baskets to satisfy redemptions could realize capital gains.

The ability to help minimize capital gains is easier in some asset classes than others. Some of this has to do with restrictions on what types of securities can be included in an in-kind basket. For example, some markets such as South Korea and India don’t allow in-kind transfers. Similarly, certain security types such as loans, securitized offerings, and derivatives can’t be included in in-kind baskets. As a result, ETFs with exposures to these markets and security types may be less tax efficient.

Many ETFs don’t distribute capital gains, or if they do, the distributions tend to be smaller and less frequent than those of other investment vehicles. We think these advantages make ETFs an excellent option for tax-conscious investors.