Investors frequently associate exchange-traded funds (ETFs)1with the absence of year-end capital gains distributions. Given this is often cited as the investment wrapper’s key benefit, it’s worth a quick recap.
Why are ETFs considered such an attractive, tax-efficient investment vehicle? Regardless of whether an ETF strategy is active or passive, three main factors at play are the ETF’s:
- Ability to trade in the secondary market on various exchanges, externalizing related transaction costs.
- Unique creation/redemption mechanism that enables exchanging securities “in kind2” with Authorized Participants (“APs”) when shares are created or redeemed on the primary market.
- Option to transact custom in-kind baskets with APs when rebalancing for portfolio optimization.
Clearing the air: These factors aren't about tax avoidance but rather tax deferral. By minimizing capital gains distributions, ETF tax efficiency lets investors defer tax bills until they sell shares, preserving more capital for market investment and potential compounded returns over time.
In fact, one in threefund selectors from wealth management firms across the globe surveyed for their 2024 outlookcite tax efficiency as one of the prime benefits of active ETFs.
Trading on an exchange
When ETF investors buy or sell shares, such transactions most likely occur on the secondary market. Trade orders are placed via a brokerage firm and then routed to exchanges to identify an appropriate counterparty. These trades are executed at a price primarily based off the ETF’s intraday net asset value (iNAV).
Since these transactions occur between two market participants and not the fund itself, existing shareholders are insulated from others actively buying and selling shares – thus avoiding taxable transactions within the ETF. In contrast, a mutual fund redemption order, for example, requires the fund to finance the redemption by either expending existing cash reserves for smaller sales or selling existing securities to raise cash for larger sales. By selling certain securities that have embedded gains, the profits are crystalized, resulting in year-end capital gains to be paid to all existing fund shareholders.
In-kind primary market ETF transfers
At any given time, the demand for certain ETFs may exceed the outstanding share supply – or vice versa. To address this imbalance, a transaction between an AP and the ETF issuer occurs on the primary market to either create new shares or extinguish existing shares. Instead of the ETF raising cash to meet a redemption, for example, a pro-rata slice of the ETF portfolio is directly transferred to the participating AP on an “in-kind” basis. No recognized capital gains are incurred by the ETF or its shareholders when securities with embedded unrealized gains are transferred from the fund to an AP.
Further, ETFs can select specific tax lots with lower cost bases to push out in the case of redemptions. Ultimately, this enables the ETF to operate with greater tax efficiency, especially when sufficient scale is reached to realize consistent natural two-way asset flows. Investors can maintain a higher level of unrealized capital gains on their books to be realized only when they choose to sell the ETF shares.
Optimization using custom baskets
Facilitating a portfolio rebalance order with an AP in the primary market via a non-pro rata portfolio slice can further enhance tax efficiency and reduce transaction costs. This “custom basket” transaction, conducted primarily for portfolio optimization and efficiency purposes, occurs on an in-kind basis without realizing any taxable gains on the basket’s securities.
As a practical example, custom baskets are particularly beneficial amid an ETF’s portfolio rebalance when certain appreciated securities require trimming. Instead of selling these securities in the open market, a custom redemption basket can be constructed that includes only a slice of the overweight names. The portfolio manager may choose specific low-cost basis tax lots and pass them along to an AP in the primary market. Similarly, if a portfolio manager wishes to completely sell out of one particular security, a custom basket is constructed to include only this single name with the entire position transferred in kind to an AP. This flexibility enables ETFs to tactically decrease costs and increase tax efficiency when shifting portfolio allocations.
Thanks to their exchange-trading feature, unique creation/redemption mechanism, and custom basket transaction option – not to mention tax loss harvesting3– ETFs can offer investors and investment professionals an added tax-efficient investment option to their financial planning toolkit.
