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Subject:  Re: What Are the Tax Advantages (If Any) of ETFs Date:  9/28/2005  12:05 AM
Author:  rkmacdonald Number:  1063 of 2247

Author: smith107 | Date: 9/27/05 2:48 PM | Number: 1057
What are the tax advantages (if any) of ETFs?

I found an article that addresses this at . It was written in 2002, and there may be newer information available now, but I think the concepts remain the same:


Zigler points out that mutual funds are almost always fully invested, and therefore keep little cash on hand to meet shareholder redemptions. The fund must sell securities to pay out the redemptions, which triggers capital gains distributions for those who remain in the fund (unless the fund is held in a tax-deferred account). Zigler notes that many fund investors were hit with a double whammy during the market downturn: their mutual funds dropped in value yet they were hit with capital gains triggered by fellow fund investor redemptions. However, several Vanguard funds experienced positive inflows during the bear market and haven't had to sell stock to meet shareholder redemptions.

In simple terms, ETF investors are insulated from the selling of shares by other investors in the fund. Exchange-traded funds redeem shares "in kind" in a sort of barter system that doesn't involve actual selling shares and resultant capital gains.

ETFs are also able to eliminate low-cost-basis stock, or shares purchased cheaply that have since risen in price, during redemptions. This feature also bolsters ETF tax efficiency. As another example, at the end of 2001 Barclays Global Investors announced zero year-end capital gains distributions for all domestic and 11 international iShares.

However, ETFs do make capital gains distributions when shares are sold to reflect index rebalancings, just like index funds. Some ETFs and index funds are optimized samples of an index and can therefore adjust holdings in the absence of a real index rebalance.

The index fund vs. ETF tax efficiency debate is likely to continue until researchers have enough data to make meaningful comparisons, perhaps even three or five years worth. The two vehicles are different enough that they will likely appeal to different types of investors. Certainly, ETFs do have disadvantages, such as broker commissions, bid/ask spreads, and premiums and discounts. However, the structure of ETFs and the limited data so far suggests they can deliver on their tax efficiency claims.

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