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ETF Shares Are Often More Tax-Efficient Than Mutual Funds

The exchange of ETF shares for shares of stock also avoids realizing capital gains when many shareholders want to unload the fund. In a regular mutual fund, when shareholder redemptions force the fund to sell stock holdings to raise the cash needed to meet those redemptions, any profits on the stock sale generate capital gains that are passed on to the remaining shareholders of the fund at the time of its annual capital gains distribution. This means that long-term shareholders might have to pay capital gains taxes because some other shareholders sold out.

In some instances, fund managers might decide to realize the gains from one of their holdings. That, too, creates a taxable capital gain for the fund shareholders, whether or not they actually sell their shares. The extent to which this is an issue depends on how frequently a fund manager turns over his portfolio and whether the market has been in an uptrend. (At the tail end of a bear market, there might be no profits to tax, in which case portfolio turnover does not create tax liabilities for the shareholders.)

The exchange of ETF shares for shares of the underlying stocks does not create a taxable event. The only way for a long-term shareholder of an ETF to realize capital gains without selling his own shares is when a change in the basket of stocks forces the sale of some shares. Because all ETFs that are currently trading in the United States are passively managed and therefore have low portfolio turnover, the risk of a large capital gains distribution is minimal. In contrast, a regular mutual fund can generate a large taxable distribution in either of two situations: first, if the portfolio manager makes a big change in his holdings, or second, if a large number of shareholder redemptions force the fund to sell stock.

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