This isn’t something most new investors think about when buying mutual funds or exchange-traded funds (ETFs). However, this scenario is extremely common and the process for addressing it is usually spelled out in the fund’s prospectus.

When a fund is experiencing a net outflow of capital (i.e., more redemption requests than capital inflows from new investors), investments must be sold to raise money. This is especially the case when the fund’s managers believe that honoring redemptions would endanger the investment of long-term investors who remain in the fund.

In-kind redemptions seek to address this issue by offering investors leaving the fund a payment other than cash, usually securities or other forms of property on a pro-rata basis. While this scenario describes what would happen if a fund experiences a cash crunch, exchange-traded funds are set up this way regardless of inflows. In other words, in-kind redemptions are a fundamental feature of the ETF asset class (more on that below).

The most common type of in-kind distribution occurs when a company pays a dividend in stock rather than in cash. Additionally, some funds pay out distributions in kind after a certain threshold. For example, if an investor redeems shares over the allotted threshold, the remainder of the redemption values are paid in kind, usually with shares of the fund. This lowers the tax penalty in the event of high redemption activity.

Don’t forget to check out this article to learn about the differences between an ETF and an index mutual fund.

For ETFs, in-kind redemptions are the primary mechanism by which redemptions are made. When an investor wants to redeem ETF shares, the distributor usually exchanges the shares to be redeemed for a basket of securities held by the ETF. Only “authorized participants” – a form of institutional investor – may redeem shares directly from an ETF. These investors are also able to contribute securities to a fund in exchange for newly issued ETF shares. Retail investors, on the other hand, can only buy and sell ETF shares through a broker.

ETF distributions are set up this way to maximize tax efficiency and minimize capital gains distributions. According to KPMG, in-kind redemptions create “more opportunities for ETFs with appreciated and liquid portfolio holdings to defer gain recognition.”

In all cases where ETFs make in-kind redemptions, the fund never has to sell securities to generate cash. As such, it avoids generating taxable gains for non-redeeming shareholders. ETFs can also use this redemption mechanism to remove capital gains and permit non-redeeming shareholders to defer taxes on their gains.

Check out this article to learn how ETFs were made for tax-loss harvesting.

Regardless of the redemption options available to ETF managers, the in-kind mechanism proves to be more attractive in a variety of circumstances. Since many ETFs employ passive index strategies, they usually have lower turnover than actively managed funds. If a passive ETF sold securities to meet redemptions, it would create a large taxable event for non-redeeming shareholders.

The redemption mechanism is also useful when we consider investor behavior. Since investors buy ETF shares on a cost-average basis, they would be sold or redeemed for a higher amount than the cost basis. Once again, this means higher tax payments on that sale.

As KPMG also noted, over the past two decades rising markets have made it more difficult for portfolio managers to manage funds on a tax-efficient basis without using the in-kind redemption tool. In fact, selling securities with a higher cost basis is a good idea only when it is done to minimize any resulting gains.

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While the in-kind redemption mechanism can help mutual funds cover a cash crunch, they are a fundamental feature of exchange-traded funds. The tax efficiency made possible through in-kind redemptions is partially responsible for the growth and widespread adoption of ETF investing over the past 15 years.

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