A. There are two main reasons why ETFs are more tax efficient.
1. More Passive Investments
Index-tracking ETFs are more tax efficient than actively managed mutual funds because churn within the ETF portfolio is inherently lower than in stock-picking investment strategies. This is true of index funds in general, including index-tracking mutual funds, not just ETFs. In other words, index funds are more efficient in part because they usually hold the same stocks over weeks and months, until a re-balance.
Capital gains are generated inside a fund when a manager sells winning positions. Funds are required to distribute those gains to their shareholders, who in turn are required to pay taxes on them. Most index-tracking ETFs don’t pay out capital gains, except for in rare cases.
In our next blog post, we will discuss the second reason why ETFs are more tax efficient - structural reason.