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Subject:  Re: What Are the Tax Advantages (If Any) of ETFs Date:  9/28/2005  12:09 AM
Author:  rkmacdonald Number:  1064 of 2248

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

After I posted my previous reply, I found an article by one of my favorite experts, William Bernstein. This one really analyzes things:


ETFs offer the possibility of greater tax efficiency. Certain asset classes are inherently tax-inefficient, because index reconstitution forces sales of appreciated shares. ETF shares are created and redeemed at the level of "authorized participants" who assemble and break apart the shares from and into their component stocks. The techniques involved here are enormously complex and center around two facts. First, when shares of an ETF are taken out of the market by sales, they are redeemed "in kind" by breaking them up into their component stocks; this is not a taxable event. Thus, "authorized participants" who do this are able to redeem the shares with the lowest cost basis, leaving the more tax-efficient high-basis shares in the fund. Open-end funds usually do the opposite, leaving the low-basis shares. Second, much of the tax-inefficiency of mutual funds or ETFs comes with the re-jiggering of the underlying indexes; in both cases, the stocks kicked out of the index must be sold for cash, incurring capital gains. The ETF advantage is that if it has incurred a large amount of share turnover because of expansion and contraction of its asset base, then when the index re-jiggering occurs, the shares sold would have a higher cost basis than the corresponding shares in the open-end fund. Two enormous caveats must be considered. First, tax-efficient large- and small-cap market funds for the S&P 500 and S&P 600, respectively, are available from Vanguard. Further, there are some asset classes, like REITs, which are tax-inefficient even in the ETF format because of dividends. So we are really only talking about large- and small-value funds here. Second, at present, the added tax efficiency is only a theoretical advantage; in fact, ETFs can and do declare capital gains distributions—about 60% did last year. Thus, the potential tax advantage will take years to prove itself. It would be well to observe how ETF small- and large-value tax efficiency pans out before calling your broker.


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