Exchange Traded Funds (ETFs) hold an advantage over mutual funds. ETFs are similar in that shareholders of both will pay any tax due on the income, dividends and short-term capital gains which are distributed. However, with an ETF, shareholders are much less likely to be subject to long-term capital gains distributions. To understand why, we need to understand the structure of both of these instruments.
When a shareholder invests in a mutual fund, they do so by exchanging cash for shares of the fund. The fund will then invest the cash in stocks, bonds, etc. The key is that investors are making a cash-for-shares exchange directly with the fund. Conversely, when an investor invests in an ETF, the investor exchanges cash for fund shares, but the exchange is between an investor and an Authorized Participant (AP), not directly with the fund.
Shares in an ETF are created by an AP. First, an AP will purchase a basket of securities through the capital markets which represents the holdings in the ETF. Then, the AP delivers the securities to the fund custodian in exchange for shares in the ETF, known as ETF Creation Units. This exchange is done in-kind as opposed to sending cash.
Finally, the AP sells the shares to the investor. Because the initial exchange is considered to be in-kind and is between the AP and the fund custodian, the shareholder is less likely to be faced with long-term capital gains. Of course, when the shareholder ultimately sells the ETF, the shareholder will pay tax on the gain in the share price, if any. The structural difference and potential absence of long-term capital gains created by third-party exchanges in ETFs makes them a compelling investment vehicle.
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