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What Makes An ETF Tax Efficient?

 April 17, 2012 12:11 PM

(By Every Day Finance) Exchange-traded fund investors know better than to ignore the cost of a particular investment in a portfolio. Most gravitate to ETFs for tax efficiency and low annual management fees relative to mutual funds. Let's explore one natural benefit to the ETF structure that makes it tax efficient.

ETF Structure Affect Tax Liabilities

Exchange-traded funds are designed as trusts, most commonly under the Investment Company Act of 1940, which allows this particular structure of a fund. As a grantor trust, the exchange-traded fund is essentially its own being – an investment company. Buying and selling the ETF, then, is just like buying or selling any other company.

But what makes this open-ended structure unique is the creation and redemption process. Open-ended funds allow for "authorized participants" (mostly major investment banks or hedge funds) to trade assets for new shares, or shares for part of the portfolio's assets. For example, a hedge fund could offer up a portfolio of S&P500 companies in exchange for shares in the SPDR S&P500 Index ETF (SPY). The hedge fund gives the ETF the appropriate amounts of stock for SPY shares, and the ETF company gives the hedge fund an appropriate amount of SPY shares for their stock.

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The opposite of this transaction is the redemption process, whereby investors can trade SPY shares for a large block of all the shares in the S&P500 index.

The Awesome Tax Efficiency of ETFs

This system of creation and redemption allows investors to skip on a majority of their capital gains tax. By virtue of the creation and redemption process, exchange-traded fund administrators can "hide" capital gains that would otherwise be passed on to investors.

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Let's use an example to demonstrate how this works. Suppose State Street Global Advisors, which is the issuer of the popular SPY ETF, has holdings in every stock in the S&P500 index to back its fund. The fund naturally holds some shares at a gain, some at a loss, and from top to bottom the fund has shares acquired at a different cost.

In the S&P500 index is Apple, which SSGA naturally owns in the ETF portfolio. State Street did not acquire all these shares at the same time. It might have two different blocks with a cost basis of $650, and $500, while the current share price might be $600.

In the redemption process, State Street can make redemptions in which it delivers stock in exchange for SPY shares. State Street can deliver the shares with a cost basis of $650 to the investor asking for redemption. This transaction essentially provides for a capital loss of $50 per share, since the current share price is $600, neutering some of the unrealized gains on the stock acquired at a cost basis of $500. Paying out the redemption with shares at a $500 cost basis would create a capital gain of $100, given that the current value of Apple shares is $600 each.

ETFs vs.

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