What is an Exchange-Traded Fund (ETF)
Discover the benefits of investing in ETFs.
Many investors may turn to exchange traded funds (ETFs) for more transparency or lower costs, but they often forget that these assets are also tax efficient. The magic of this lies in how shares are exchanged. The issuer creates and redeems existing shares through an “in-kind” process involving large institutional investors called authorized participants (AP). The APs have an agreement with the ETF trust and their custodial bank that allows them to create or redeem shares of the ETF in blocks known as creation units.
During the creation process, the authorized participant delivers a basket of securities held in the ETF to the issuer in exchange for a creation unit. In a redemption, however, the authorized participant receives a basket of securities while the fund collects a creation unit. Since these transactions happen in shares and not in cash, there are no capital gains. What’s more, the law states that capital gains are not recognized at the time of the transaction and thereby not considered a taxable sale.
This 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 upon sale. Below are 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, this may be a cash transaction and a taxable event for the ETF.
Corporate events (stock splits, merger 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.