[The following "ETF Industry Perspective" is sponsored by IndexIQ]
If you've been a shareholder in exchange-traded funds (ETFs) over the past year, you generally expect to see little or nothing in the way of capital gains taxes—at least generated by the activity of the fund. But why is that? On the most basic level, traditional mutual funds and ETFs are treated the same—both are subject to taxes on capital gains and income. So if you buy an ETF at $10 and sell it for $11, you have a potentially taxable gain (see your tax advisor regarding your individual circumstances) of $1.00. The same goes for dividend and interest income paid out during the year.
The basic difference in tax treatment comes from the way the holdings in the portfolios are traded—and the generation of taxes at the fund level. When you or a client buy or sell shares in an ETF, you're conducting a transaction on an exchange. (With a traditional mutual fund, you're buying shares directly in the fund.)
To manage the flows this creates, the ETF sponsor also has to buy and sell securities, but this can be done with other market participants as what is known as an "in-kind" transaction. Unlike cash redemption or the cash trade of a mutual fund, in-kind exchanges do not trigger capital gains. Another benefit: When selling, the ETF manager can choose to redeem-out in-kind securities with the lowest basis (and therefore the highest return), further lessening the likelihood of future capital gains.
Mutual funds don't allow for this in-kind trading. When money comes in or goes out and the portfolio manager wants to sell shares to rebalance or meet redemptions, he generally sells those shares on an exchange. Some of these holdings may have embedded gains, triggering a capital gain for the portfolio. Those gains have to be distributed to shareholders every year.
(By way of contrast, our own family of ETFs has generated little to no capital gains based on trading in the portfolios since the first fund, IQ Hedge Multi-Strategy Tracker ETF (QAI) was introduced in 2009.)
Mutual funds and ETFs each have their own advantages, based on investment strategy and structure, among other factors. But from a purely tax-efficiency perspective, ETFs generally come out ahead for most investors.