ETFs have a significant advantage over other investment structures when it comes to tax efficiency. See how efficiency correlates to the client experience.
When it comes to tax efficiency, ETFs can hold a considerable advantage over other investment structures. This advantage is important, especially as it relates to the client experience. Greater control and tax efficiency create the potential to keep more money invested in the market and receive greater capital appreciation over time. But why exactly are ETFs more tax-efficient? It all comes down to the creation/redemption process.
The Creation/Redemption Process
The creation/redemption mechanism is at the heart of ETF’s tax advantages relative to mutual funds. ETF shares can only be created or redeemed by Authorized Participants (or APs).
In order to create these new shares, an ETF issuer makes a list of the underlying holdings and weights that are needed to make up this basket. The AP delivers this basket to the issuer, receiving shares of the ETF in return. When shares are redeemed, this process happens in reverse.
One benefit of this process is that it keeps the NAV of the ETF in line with the underlying securities. But this transfer between the AP and the issuer is known as an “in-kind transfer” and receives favorable tax treatment since the issuer does not need to sell shares of the securities. When redeeming shares, Issuers can provide the AP with the shares with the lowest cost basis without triggering capital gains, keeping the ETFs tax burden low.
Timing Is Everything
By keeping the tax burden of the ETF itself low, these investments typically do not pay out capital gains like mutual funds do since the low cost basis securities can be shifted out without triggering taxes.
Mutual funds, on the other hand, must meet redemptions while selling securities from within the fund. This means that investors within a mutual fund can be required to pay capital gains regardless of whether they’ve sold shares of their investment or even benefitted from the price appreciation, giving the investor little control over the timing of this taxation.
The creation/redemption process doesn’t mean that taxes are eliminated – only deferred. ETF investors that purchase a fund whose shares are appreciating will need to recognize a capital gain and pay the appropriate taxes. But ETF investors typically only pay taxes when they sell shares of their ETF investment, giving them full control over the timing of these tax obligations.
Particularly for long-term investors, deferring this gain until shares are sold rather than distributing capital gains throughout the holding period means that more money can be kept in the market, working for the investor. This tax advantage has been one of the main drivers encouraging advisors and mutual fund firms to shift to the ETF wrapper, delivering their strategy in a tax-efficient way to more of their clients and investors.
If you’re interested in learning more, contact us to discuss how your strategy could benefit from transitioning into an ETF.
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