No. of Recommendations: 3
We've previously discussed how ETFs exploit the in-kind transfer tax loophole. But a remark I read on another site got me wondering if the frequent creations and redemptions (ex: due to day traders) would have the side affect of raising the cost basis of the stock for the ETF holders.

So I emailed this to iShares:
I have some questions regarding how the cost basis of holdings in your
ETFs is calculated. I own IJR and IJS, but my questions apply to all
ETFs you offer.

As I understand it, the market makers for an ETF can create or redeem
shares whenever there is excess demand or supply. And that that the
creation and redemption is an an “in kind” trade and therefore not a
taxable event for the ETF shareholders.

When ETF shares are redeemed by the market maker for stock shares, are
you able to turn the stock shares on which you have the lowest cost
basis? And when ETF shares are created, are you able to take the current
prices of the underlying stock as the basis for those stock shares?

And if both of the above are true, then if the market maker creates and
redeems ETF shares frequently (e.g. if there was extensive day trading
of the ETF occurring), wouldn't that benefit long term ETF holders in
that it would raise the cost basis of the underlying stock shares? (so
that if a stock was replaced in the index there would be less of a
capital gain)

Thanks for your help,


Their response was (emphasis mine):

Thank you for your interest in iShares Funds, from Barclays Global Investors.

You are correct in saying that BGI will transfer in-kind to the authorized participants the stocks with the lower cost basis during redemptions and take on the new cost basis of the stock during creates.

As far as long-term and short-term investors go, that is another element that helps keep iShares funds more tax efficient than traditional mutual funds. The shareholders do not effect the underlying portfolios, since their transactions are conducted on an exchange via a broker/dealer. With regular mutual funds, if several shareholders want to liquidate, the fund may have to sell off securities to raise cash to meet the liquidations, which can generate capital gains that will be distributed to long-term investors. With iShares funds, buyers and sellers are paired together on the secondary market (stock exchange), which does not effect the funds' underlying portfolio in any way.

iShares do not guarantee that they will not distribute capital gains.

If you have any further questions, please call our Investor Services Representatives at 1-800-iShares (474-2737) Monday - Friday 8:30 AM to 6:30 PM (est.), respond to this e-mail, or visit our web site at www.iShares.com
Thank you again for your interest in iShares Funds.


So basically, high day-trading on ETFs benefits long term holders of the ETF because it raises the cost basis of the stock held in the ETF, reducing future capital gains distributions.

-Joe
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