by ETFZone staff

As luck would have it ETFs are also quite tax-efficient. Because of the way they are created and redeemed, they allow an investor to pay most of his capital gains upon final sale of the ETF, delaying it until the very end. There is no way to avoid capital gains, but delaying it is valuable because the amount that would have been paid to taxes can continue to accumulate wealth. Exactly how much an investor benefits after-tax depends on their marginal tax rate, the return of the investment, and how long they hold the investment. Overall, ETFs are similar to tax managed index mutual funds, slightly more efficient than standard mutual funds, and significantly more efficient than actively managed mutual funds.

Traditional mutual funds accumulate unrealized capital gains liabilities for stocks that have risen in value. Upon sale of these stocks the fund calculates and periodically distributes the capital gains to its investors in proportion to their ownership. The following table illustrates a comparison of ETFs versus standard index mutual funds:

Capital Gains Distributions as a Percentage of Assets, August 2000-August 2001

(Source: Bloomberg, from May, 2002 issue of Financial Planning Magazine)

Both types of funds in the table have modest distributions, certainly in comparison to actively managed mutual funds. And the more turnover from trying to pick stocks, the more an active fund will force investors to pay the IRS. It's an ugly and little discussed fact that active mutual fund investors can end up paying other investors' tax bills, especially in a bear market. That's because investors who sell out before the day of record for that distribution will not receive the tax bill, while loyal investors who stay in will pay it for the entire amount!

How is it ETFs are so efficient? Through a regulatory loophole, ETFs are considered to be created by trading equivalent certificates (the ETF for the many stocks that make up the basket) in what is called an in-kind trade. This exchange of essentially identical items does not trigger capital gains, according to the IRS. Traditional mutual funds must go into the open market and exchange cash for stocks and vice versa, which trigger realization of gains. It's a subtle difference, admittedly, but which results in an advantage for the ETF investor.

As always, there are exceptions. Occasionally an ETF fund that is only a few years old may throw off unusually high distributions, in a market downturn. But this is atypical.