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 and only rebalance their portfolios when significant changes occur to the underlying benchmark.
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 and simple investment strategies combined with low expense ratios.
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.