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Sources of Tax Efficiency in ETFs

ETFs are often described as more tax efficient than mutual funds. While this is not a hard and fast rule, two tax-efficient mechanisms, available to all types of funds, are commonly employed by ETFs: low portfolio turnover strategies and in-kind redemptions. ETFs that do not use these mechanisms may not be more tax-efficient than other funds, and in fact may be less tax-efficient than mutual funds that do use them.

It is important to note that while these strategies reduce capital gains distributions to investors while they are holding ETF shares, investors ultimately pay taxes on any capital gains when they sell their ETF shares. Thus, these strategies enable tax efficiency, but not tax avoidance:

Low portfolio turnover strategies:

The sale of portfolio securities by a fund may trigger capital gains distributions to shareholders. Therefore, funds that experience lower portfolio turnover are generally more tax-efficient than those that buy and sell securities regularly.

Index strategies, which most ETFs and many mutual funds follow, generally have lower portfolio turnover than actively managed strategies. This is not always the case, however; some indexes rebalance frequently, and some active managers limit portfolio turnover to minimize capital gains distributions.

Additionally, the fact that most trading of ETF shares occurs on the secondary market, rather than directly with the ETF, may reduce the frequency with which the ETF needs to sell portfolio securities to account for share redemptions. Mutual funds that do not experience regular net outflows (outflows in excess of corresponding inflows) may also limit the sale of portfolio securities to meet redemptions.

In-kind redemptions:

Many ETFs require authorized participants to create and redeem shares in kind—that is, to exchange ETF shares for a basket of securities, rather than cash. This allows the ETF to avoid selling securities to raise cash to meet redemptions, and thereby also prevents capital gains distributions. Additionally, when redeeming in kind, an ETF can provide the authorized participant with the underlying securities with the lowest cost basis, further reducing the ETF’s tax burden. Other types of investment products, including mutual funds, may also use tax-efficient strategies to reduce capital gains, but the ETF structure encourages their use.

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