What Makes ETFs Tax Efficient? | John Hanco*ck Investment Mgmt (2024)

What Makes ETFs Tax Efficient? | John Hanco*ck Investment Mgmt (1)

Are ETFs more tax efficient than mutual funds?

All else equal, making a choice between investing in an ETF and a mutual fund often comes down to cost—both the cost represented in the expense ratios as well as the cost involved in taxable distributions. In this regard, ETFs are widely recognized as generally being cheaper and far less likely than mutual funds to distribute capital gains.

Over the past five years, on average, less than 6% of equity ETFs paid capital gains to shareholders, while an average of 65% of equity mutual funds made distributions. Even during last year’s market downturn, many mutual funds distributed capital gains while remaining a relatively rare event for ETFs.

Equity ETFs are infrequent distributors of capital gains

Percentage of funds paying gains (%)

What Makes ETFs Tax Efficient? | John Hanco*ck Investment Mgmt (2)

Source: Morningstar Direct, September 2023. Compares all funds in the U.S. equity and international equity categories.

An ETF's potential for capital gains may depend on its category

When we look at the composition of the ETFs that distributed gains last year, we learn that some parts of the market were more likely than others to experience a distribution. Nearly half of the ETFs that distributed capital gains in 2022 belonged to the international equity category, with both currency hedging and local market securities laws helping to explain why this occurred.

However, if you own an equity ETF that’s not focused on a relatively illiquid area of the market, such as international or emerging markets, or filled with sophisticated security types and leverage, chances are you won’t receive a capital gains distribution in any given year.

Mutual funds run on cash transactions

How do most ETFs seem to reliably avoid making distributions? The answer has to do with the unique way that ETFs are structured, helping to differentiate them from mutual funds.

The average mutual fund is constantly engaged in cash transactions. When investors want to buy shares of an open-end mutual fund, the fund issues new shares as it processes investors’ tendered cash, typically putting this cash to work by buying stocks or other securities for the fund’s portfolio. When investors want to redeem their shares in sufficiently large quantities, the fund must sell securities to meet the redemption requests.

Mutual funds are caught up in cash flow

What Makes ETFs Tax Efficient? | John Hanco*ck Investment Mgmt (3)

Source: John Hanco*ck Investment Management, 2023.

In other words, investors and traditional mutual funds are locked in a circuit of cash transactions that generates capital gains potential for the fund and its investors, regardless of whether they personally sell any shares.

ETFs benefit from creation/redemption process

ETFs are insulated from engaging in these types of cash transactions, which is the key to their tax efficiency. Rather than creating or redeeming shares through cash transactions made directly with fund investors and the underlying markets, ETFs are engaged in a separate circuit of share creation and redemption—a process of in-kind transactions that isn’t considered to be a taxable event.

ETFs can create and redeem shares without cash

What Makes ETFs Tax Efficient? | John Hanco*ck Investment Mgmt (4)

Source: ETF.com, 2023. AP refers to authorized participant.

In the ETF share creation/redemption process, the ETF manager works with authorized participants (or APs) to bundle (purchase for share creation) or disassemble (sell for share redemption) an underlying basket of the fund’s securities. The process of bundling securities and delivering them into the ETF in the form of a creation unit occurs in kind and allows the fund to inject ETF shares of equivalent value into the market, satisfying rising investor demand.

In the case of declining ETF demand, the fund and the AP work to disassemble creation units. ETF shares are returned to the fund by the AP in an in-kind exchange for a basket of securities of equivalent value. The AP then sells that basket of securities to raise the cash necessary to meet investor redemptions.

Neither mechanism of creation or redemption is taxable to the ETF itself—except for some situations where the underlying securities are more illiquid or contract based, limiting their ability to be transferred in kind. In such cases, the fund would need to sell the security for cash tender, generating tax consequences.

This creation and redemption process happens behind the scenes and isn’t visible to the investor; however, this feature plays an important role in explaining why ETFs usually offer greater tax efficiency relative to mutual funds.

ETF investors may still be taxed on their gains

For the investor who buys and sells ETF shares on the secondary market, the potential for capital gains remains. Indeed, whenever you sell a capital asset, whether it’s a house, jewelry, antiques, stocks, or shares of a mutual fund or ETF, if you receive more cash than you paid for the asset, your resulting capital gain may be regarded as taxable income.

But the key difference to understand is that, unlike a mutual fund, the average ETF isn’t a reservoir of embedded gains potential. While mutual funds are locked in a circuit of buying and selling capital assets with and for cash—and distributing realized gains to shareholders—ETFs operate in a circuit of in-kind transactions, where the “in-kind ability” of the underlying basket of securities determines whether a gain is even possible to produce. It’s important to understand that the lower incidence of capital gains distributions isn’t a way to avoid taxes, but it can potentially defer taxes, leaving more money invested in the market until investors decide to sell their shares.

To learn more about some of the unique strategies ETFs can help you pursue, explore our page on ETF investing.

The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsem*nt of any security, mutual fund, sector, or index. Past performance does not guarantee future results.

It is important to note that there are material differences between investing in an ETF versus a mutual fund. ETFs trade on the major stock exchanges at any time during the day. Prices fluctuate throughout the day like stocks. ETFs generally have lower operating expenses, no investment minimums, are tax efficient, have no sales loads, and have brokerage commissions.

Mutual funds trade at closing NAV when shares are priced once a day after the markets close. Operating expenses may vary. Most mutual funds have investment minimums and are less tax efficient than ETFs; many mutual funds have sales charges and they have no brokerage commissions.

This material does not constitute tax, legal, or accounting advice, is for informational purposes only, and is not meant as investment advice. Please consult your tax or financial professional before making any investment decisions.



  • Investing basics


  • Equities
  • Taxes
  • ETFs
What Makes ETFs Tax Efficient? | John Hanco*ck Investment Mgmt (2024)


What makes ETFs tax-efficient? ›

Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.

What makes a fund tax-efficient? ›

Funds that employ a buy-and-hold strategy and invest in growth stocks and long-term bonds are generally more tax-efficient because they generate income that is taxable at the lower capital gains rate.

What is the key advantage of ETF? ›

ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts. As with all investment choices there are elements to review when making an investment decision.

What are some of the advantages and disadvantages associated with investing in ETFs? ›

In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends. Still, unique risks can arise from holding ETFs as well as tax considerations, depending on the type of ETF.

Are ETF funds tax-efficient? ›

ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.

Which ETF is most tax-efficient? ›

Top Tax-Efficient ETFs for U.S. Equity Exposure
  • iShares Core S&P 500 ETF IVV.
  • iShares Core S&P Total U.S. Stock Market ETF ITOT.
  • Schwab U.S. Broad Market ETF SCHB.
  • Vanguard S&P 500 ETF VOO.
  • Vanguard Total Stock Market ETF VTI.

How to tell if an ETF is tax-efficient? ›

The most tax efficient ETF structure are exchange traded notes. ETNs are debt securities guaranteed by an issuing bank and linked to an index. Because ETNs do not hold any securities, there are no dividend or interest rate payments paid to investors while the investor owns the ETN.

What does tax-efficient investment mean? ›

Tax efficient investing is a strategy that helps you maximize your returns by limiting any losses to taxes. This means your tax burden is lower when you seek out tax-efficient investments.

How are ETFs taxed? ›

Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.

What are three cons of ETFs? ›

Disadvantages of ETFs
  • Trading fees. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ...
  • Operating expenses. ...
  • Low trading volume. ...
  • Tracking errors. ...
  • The possibility of less diversification. ...
  • Hidden risks. ...
  • Lack of liquidity. ...
  • Capital gains distributions.

What is the primary disadvantage of an ETF? ›

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.

What is the best way to explain ETF? ›

An exchange-traded fund, or ETF, is a basket of investments like stocks or bonds. Exchange-traded funds let you invest in lots of securities all at once, and ETFs often have lower fees than other types of funds. ETFs are traded more easily too. But like any financial product, ETFs aren't a one-size-fits-all solution.

What are the best ETFs for 2024? ›

Best ETFs as of May 2024
TickerFund name5-year return
SMHVanEck Semiconductor ETF31.19%
SOXXiShares Semiconductor ETF26.35%
XLKTechnology Select Sector SPDR Fund21.30%
IYWiShares U.S. Technology ETF20.70%
1 more row
4 days ago

What are the benefits of ETFs compared to stocks? ›

ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.

Why are ETFs more efficient than mutual funds? ›

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often. However, ETFs also have a structural ability, called the in-kind creation/redemption mechanism, to minimize the capital gains they distribute.

How do you save taxes on ETFs? ›

One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way, your gains receive long-term capital gains treatment, lowering your tax liability.

Are ETFs more tax-efficient than index funds? ›

The capital gains taxes you'll pay

ETFs are more tax-efficient than index funds by nature, thanks to the way they're structured.

Why do ETFs avoid capital gains? ›

Why? For starters, because they're index funds, most ETFs have very little turnover, and thus amass far fewer capital gains than an actively managed mutual fund would. But they're also more tax efficient than index mutual funds, thanks to the magic of how new ETF shares are created and redeemed.

Is qqq tax-efficient? ›

And while the QQQ does pay a dividend, it's small, with a 12-month distribution rate of 0.83%. The tax effects of that small yield are inconsequential even to higher earners. All in all, the QQQ's represent one of the best ETFs to get equity exposure and lower taxes.

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