Much of the oft-cited tax efficiency of an ETF actually depends on the fund’s underlying holdings and strategy, as well as how it’s used by investors, says Morningstar’s director of North American ETF research Paul Justice.
Paul says that “the real tax efficiency from ETFs comes from the action of other investors in the fund or the fund flow aspect. With a lot of people buying and then selling out, if you are in a mutual fund structure, you make get hit with a tax bill even if you don’t sell it. With an ETF that’s typically not going to happen. You neutralize that component of the taxation. But if within the ETF portfolio itself, if there is a lot of rebalancing that goes on or a lot of changes of the constituents, you are still going to have the potential to generate taxable gains there at the same level that you’d see in the mutual fund–that doesn’t go away. The ETF is just a look-through vehicle; it’s not this magical tax evading vehicle.”
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