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I am trying to understand the cost efficiency of tracking an index using a mutual fund, ETF, or ETN. I can't figure out how the ETN avoids the drag of the capital gains tax.

I understand how index mutual funds do it: trading is infrequent and the costs of customer redemptions including taxes are distributed among the other holders. Index ETFs use institutional investors to absorb trading costs on the secondary market. The institutions do this because their big blocks of ETF shares can be used profitably in abitrage trading. As a result, the ETF rarely has to adjust its holdings, keeping costs way down.

But the ETNs do not hold any securities by design. They use the proceeds of investor note purchases to buy derivatives on what they are supposed to be tracking, essentially hedging their exposure. Now let's say the index goes up and a note holder wishes to cash out. The firm issuing the ETN will have realized a gain in the hedge position that they purchased with the original investment. The hedge is liquidated, the note holder is paid the profit and returned the original principal (less the note's tracking fee). But the note issuer (ie. the investment bank) will have to pay capital gains tax on the hedge. Presumably this tax will be passed on to the note holder. This would represent a substantial cost and greatly affect the efficiency of the position -- the note would track the index less the stated fee (typically 85 basis points) and less the capital gains tax paid by the investment bank. The note holder then gets taxed on what's left, which means there is double taxation.

I know this can't be correct, so I'd very much appreciate someone clarifying how it works. I'm tired of Google searching.
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