Investment Insights

The Tax Benefits of ETFs

January 20, 2020

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.

For illustration purposes only

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.

Invesco does not offer tax advice. Please consult your own tax advisor for information regarding your own tax situation. While it is not Invesco' intention, there is no guarantee that a Fund will not distribute capital gains to its shareholders.
Investors should be aware of the material differences between mutual funds and ETFs. ETFs generally have lower expenses than actively managed mutual funds due to their different management styles. Most ETFs are passively managed and are structured to track an index, whereas many mutual funds are actively managed and thus have higher management fees. Unlike ETFs, actively managed mutual funds have the ability react to market changes and the potential to outperform a stated benchmark. Since ordinary brokerage commissions apply for each ETF buy and sell transaction, frequent trading activity may increase the cost of ETFs. ETFs can be traded throughout the day, whereas, mutual funds are traded only once a day. While extreme market conditions could result in illiquidity for ETFs. Typically they are still more liquid than most traditional mutual funds because they trade on exchanges. Investors should talk with their advisers regarding their situation before investing.