Exchange-traded funds (ETFs) invest in individual securities, such as stocks, bonds, and derivatives with specific investment objectives. In many cases, ETFs are passively-managed where they follow a certain equity or bond index such as the S&P 500. In many cases, ETFs only rebalance their portfolios when significant changes occur to the underlying benchmark, requiring a fund manager to actively reselect certain stocks to make sure the ETF is still following the fund or achieving the specific fund's objectives (such as with leveraged ETFs).

Shares of ETFs are traded like stocks on major U.S. stock exchanges, such as the NASDAQ and the New York Stock Exchange. ETFs have become very popular among investors due to their transparent, diverse, and simple investment strategies combined with often very low expense ratios.

Key Takeaways

  • ETFs have become a popular investment vehicle due to their simple, diverse, and low-fee strategies. When ETFs are simply bought and sold, there are no capital gains or taxes incurred.
  • Because ETFs are by-and-large considered "pass-through" investment vehicles, ETFs typically do not expose their shareholders to capital gains. However, although rare, ETFs can generate capital gains that are transferred to shareholders on occasion due to one-time large transactions or unforeseen circumstances.
  • For example, an ETF may incur a capital gain if it needs to drastically rebalance its portfolio due to substantial changes in the underlying benchmark.

Understanding ETF Tax Structures

As discussed, shares of an ETF are bought and sold the same way that exchanges happen on the stock market. There are sellers of those who already own the ETF and buyers of those who are interested in investing in the ETF. Because of this exchange, there is no real sale of securities in the ETF package, meaning there is also no subsequent capital gains tax liability incurred.

However, there are other special circumstances involving an ETF's actual sale of securities which result in capital gains and the capital gains tax associated with it.

How Exchange-Traded Funds Generate Capital Gains

ETFs can generate capital gains that are transferred to shareholders, typically once a year, triggering a taxable event. Although very rare, ETFs have capital gains on occasion due to one-time large transactions or unforeseen circumstances. Because ETFs are structured as registered investment companies, they act as pass-through conduits, and shareholders are responsible for paying capital gains taxes.

Holding ETFs in a taxable account typically generates smaller capital gains when compared to mutual funds because ETFs do not necessarily have to sell the underlying securities to finance investment inflows and outflows. Through authorized participants, ETFs can create or redeem "creation units," which are blocks of assets that represent an ETF's securities exposure on a smaller scale. By doing so, ETFs typically do not expose their shareholders to capital gains.

Occasionally, an ETF may incur a capital gain due to some special circumstances, where it has to drastically rebalance its portfolio due to substantial changes in the underlying benchmark. Also, leveraged, inverse, and emerging market ETFs typically cannot use in-kind delivery of securities to create or redeem shares. This triggers capital gains more often for these kinds of ETFs when compared to index ETFs.