Benefits of ETFs to the tax-aware investor

Investors can seek to minimise the impact of capital gains taxes by choosing tax-efficient investment products and keeping an eye on investment costs. Among their many advantages—intraday liquidity, transparency and ease of use— exchange traded funds (ETFs) are highly touted for their tax efficiency and low cost. (Note that tax efficiency refers to how well an investment minimises an investors’ taxes while they own it.)

First and foremost, ETFs typically generate fewer capital gains distributions than unlisted funds for two reasons:

– Low portfolio turnover: Because they track an index, ETFs tend to have lower turnover than actively managed unlisted funds, thereby reducing the potential for capital gains distributions.
– Secondary market transactions: Unlike unlisted funds, when ETF investors sell their units, portfolio managers do not need to sell securities to raise cash for the redemptions. So, unlike traditional unlisted funds, one ETF investor’s sell decision has no impact on other investors and capital gains distributions are kept low. These distributions, taxable to all investors, regardless of how long they have owned the fund, can result in a capital gains tax bill, even in years when the unlisted fund registers a loss.

The unique structure of ETFs gives tax-aware investors a chance to minimise capital gains distributions and allow for more assets to remain invested – increasing the growth potential of the investment.

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