ETF Tax Efficiency Explained

Rick Genoni: The growth of the active ETF market has been staggering, due in large part to the structural benefits of the wrapper. Among those most often mentioned are portfolio transparency, intraday tradability, and the potential for lower costs. For most investors, these are dwarfed by the tax benefits that ETFs provide. And there's three drivers to this. The first is tied to the fact that ETFs are exchange traded. The majority of ETF shares change hands in what is known as the secondary market on the exchange. So, if I'm selling and you're buying, we can agree on a price for you to buy those shares from me without either of our transactions hitting the portfolio. With a traditional mutual fund, your purchase would have resulted in transaction costs for the portfolio to trade the cash. And my redemption may have led to the portfolio selling stocks or bonds to raise cash and possibly triggering capital gains for all shareholders. So, the fact that the majority of ETF shares change hands on the secondary market means the portfolio is shielded from transaction costs and capital gains resulting from those trades. The second driver is tied to how money typically moves in and out of an ETF. I noted that the majority of ETF trading takes place in the secondary market, but when there's not an actual buyer on the other side, ETF shares can be redeemed directly with the fund in exchange for in-kind stocks or bonds. This is known as the primary market. Because this trade is done in-kind, the portfolio manager can usher out the lowest cost lots. This not only doesn't trigger a capital gain, but it raises the cost basis within the fund. This in-kind transaction is beneficial in meeting a redemption in the fund but can also be used to reposition the portfolio. And third, just like mutual funds, an ETF can carry forward losses to offset future capital gains. It's important to remember that while ETFs are more tax efficient and help to manage capital gains driven by trading inside the fund, that doesn't mean investors will not pay capital gains. I hope you found this video helpful and now have a better understanding of how ETFs can provide better outcomes for you and your clients and help you keep more of what you've earned.