Exchange traded funds (ETFs) are truly unique investment products, endowed with a number of specific advantages. One of the ‘pros’ of ETFs is their tax efficiency, which is a direct result of how ETF shares are created and redeemed.
In fact, it is the creation/redemption process that drives a significant part of the ETF tax efficiency story.
When investors in mutual funds make redemptions, shares held within the fund need to be sold in order to raise cash to meet that redemption, triggering a taxable event. This isn’t always the case with ETFs.
“ETFs create and redeem existing shares through an ‘in-kind’ process with market participants called authorized participants (APs) and market makers. APs have a legal agreement in place with an ETF trust and their custodial bank allowing them to create or redeem shares of the ETF in blocks known as creation units,” according to Invesco. “In this process, the tax code provides that capital gains are not recognized at the time of the transaction and are not considered a taxable sale, making an ETF a relatively tax-efficient structure. Thus, this structure may create a meaningfully different after-tax return experience between an ETF and another type of investment vehicle — even if both track the same index.”
ETFs: Trusting the Investment Process
ETFs minimize tax liabilities by paying large redemptions with shares of stock. The shares with the lowest cost basis in the trust are given to the redeemer. The result is an increase in the cost basis of the ETFs overall holdings, but a reduction in capital gains. The low turnover means that capital gains in ETFs are relatively rare as a result of the creation/redemption process.
“During the creation process, the market maker delivers a basket of securities held in the ETF’s portfolio to the ETF sponsor in exchange for a creation unit,” adds Invesco. “For a redemption, the same in-kind process is used except the market maker receives the basket and the fund receives the creation units. Often times during the creation and redemption process, APs work directly with market makers who assume the risk of holding a certain number of shares of a particular security to facilitate the trading of that security.”
How ETF portfolios re-balance themselves also pertains to the tax efficiency story.
“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,” concludes Invesco.
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