It’s a well known fact that ETFs offer certain tax advantages over mutual funds. How do they come about? For more details please read “The ETF Creation and Redemption Process Explained:”
Exchange traded funds (ETFs) are truly unique products with a number of advantages. One of the “pros” of ETFs is their tax efficiency, which is a direct result of how ETF shares are created and redeemed.
The basic creation and redemption process of ETF shares is practically the exact opposite of mutual fund shares, writes James E. McWhinney for Investopedia. When investors in mutual funds make redemptions, shares held within the fund need to be sold in order to raise cash to meet that redemption, triggering a taxable event. This isn’t always the case with ETFs, though.
ETFs minimize tax liabilities by paying large redemptions with shares of stock and the shares with the lowest cost basis in the trust are given to the redeemer. The result is an increase in the cost basis of the ETFs overall holdings but a reduction in capital gains. The low turnover means that capital gains in ETFs are relatively rare as a result of the creation/redemption process.
While minimizing tax liabilities is a unique benefit of ETFs, it does not mean that you should forget about mutual funds altogether.
To me, it’s all about selecting the most appropriate investment at the time you are planning to deploy money in the market. In terms of trend tracking this means that a mutual fund that steadily goes with the trend without too much volatility is preferable to a tax advantaged ETF that bounces around like super ball in a trampoline factory.
This is exactly what happened during this current buy cycle, especially in the international arena, where more mutual funds than ETFs remained below their 7% sell stop limit. I touched on that in “When Less Is More” and “Using The Benefit Of Hindsight.”