This is an extended version of the article found in the November 2012 issue of Investment Advisor.
Exchange-traded funds are often regarded as more tax efficient than traditional mutual funds largely due to the fact that many ETFs have been able to avoid the annual capital gains distributions that often frustrate investors in traditional mutual funds. As we progress toward the end of another tax year, many investment advisors are also finding ETFs to be effective tools for tax planning purposes.
ETFs' Tax-Efficient Structure
The relative tax efficiency of many ETFs is principally a result of the process by which ETF shares are created and redeemed. For most plain-vanilla equity ETFs, the creation and redemption of shares is facilitated by large institutional investors via an in-kind exchange of an ETF's underlying holdings for large blocks of ETF shares known as "creation units." This process generally enables these ETFs to grow and contract without forcing a fund's portfolio manager to buy or sell securities, potentially realizing capital gains and triggering taxable distributions to investors.
However, not all exchange-traded products share in the tax efficiency associated with plain-vanilla equity ETFs. For example, levered and inverse ETFs are often less tax efficient because these funds generally utilize a high level of portfolio turnover to achieve their objectives, increasing and decreasing exposure to various asset classes on a daily basis via derivatives, such as swaps and futures contracts. As a result, many levered and inverse ETFs have historically made substantial capital gains distributions to investors.
Additionally, there are a few odd cases in which ETFs may produce less tax efficient exposure than their underlying holdings. Such is the case for ETFs that track master limited partnership indexes. As discussed in August's ETF Advisor (See "The Hidden Tax Burden of MLP ETFs"), when an ETF allocates more than 25% of its portfolio to MLPs, it no longer qualifies as a tax-exempt, regulated investment company; instead, these funds are subject to federal corporate income tax. This tax liability is reflected in the daily calculation of a fund's net asset value, which has often resulted in significant tracking error between MLP ETFs and the indexes that they follow.
ETFs for Tax Planning Purposes
While the tax efficiency of individual ETFs may differ based largely on the asset classes in which the funds invest, ETFs in general have become popular tools for managing the tax liability of investment portfolios held in taxable accounts.
