ETFs & Tax Efficiency
Mutual funds realize capital gains caused by portfolio turnover and are obligated to distribute those gains to investors on an annual basis. This erodes returns for unitholders in taxable accounts. But the only capital gains ETFs usually realize occur when changes are made to the benchmarks they track, minimizing realized capital gains. For example, when a new company joins the S&P/TSX 60 Index, another company must be dropped. An S&P/TSX 60 Index fund manager will make the same shift in the fund's portfolio.
Trading in traditional index mutual fund portfolios is typically driven by changes to the indexes, the maintenance of diversification requirements, and liquidity management. While ETFs may realize gains due to index rebalancing or diversification requirements, trading is not required to provide liquidity. Since ETF unitholders buy and sell units on the exchange ETFs never have to sell units to provide cash for unitholder redemptions, so ETF investors aren't penalized with tax consequences when others sell their units.
Source: Barclays Global Investors Canada Limited. Used with permission. Adapted for use by Desjardins Online Brokerage.