ETF v Mutual Fund

QUESTION: Are ETFs really better than a mutual fund for tax purposes?

HS

ANSWER: The primary difference between mutual funds and ETFs (exchange-traded funds) is that while an open-end mutual fund is priced once based upon the market closing, ETFs as well as a closed-end mutual funds trade all day. This actually goes back to the Panic of 1966 when mutual funds were open-ended but traded on the exchange and were bid up and down based on emotion rather than net asset value. The crash took place because mutual funds were at times selling well above net asset value.

If we look at the reforms post-1966, investors in mutual funds buy or sell them directly from the mutual-fund companies themselves. That creates a different tax structure than an ETF in which purchases go to the market and the ETF is simply created by purchasing the underlying basket.

Mutual funds and most ETFs are governed by the Investment Company Act of 1940. Therefore, this legislation treats them like a pass-through company. When a mutual-fund investor wants to sell, the fund sells shares of appreciated stock to generate cash which creates a taxable capital gain. Since most funds operate as simple pass-through vehicles, those tax liabilities from the gains accrue to all investors in the fund including those who have not sold any holding.

ETFs actually do avoid that type of tax issue. ETFs are not direct buyers or sellers of shares as a mutual fund. The ETF is created by a market maker with a special contract with the ETF provider. The investor has the newly created ETF share which is created by purchasing all of the holdings in the underlying ETF. This basket of shares is given to the ETF issuer thereby creating the ETF shares.

Because an ETF is not a direct buyer of the underlying shares as in a mutual fund, the ETF itself is not a buyer or seller. The basket of shares are swapped and are therefore in-kind transactions, thus there is no pass-through capital-gains tax bill. This is the tax advantage of an ETF over a mutual fund.

Latest Posts

Ending Penny Production

President Donald Trump directed the Treasury Department to cease minting pennies. The penny has been circulating for 233 years, first established in 1792. Trump has been against the creation of [...]
Read more

Biden and Blinken Lose Security Clearances

The Trump Administration has determined that a handful of current and former public servants do not need access to sensitive government information. “JOE, YOU’RE FIRED!” the president posted on Truth [...]
Read more

Letita James and 20 Dem AGs Attack DOGE

New York Attorney General Letitia James will not stop her relentless manhunt against Donald Trump. Her attempts to prevent Trump from taking the presidency failed. “This illegitimate president [Trump] — [...]
Read more

The 2025 Canadian Report

This is quite an extensive report with historical details of the numerous attempts to merge Canada with the United States, and there was previously a movement in Quebec calling itself [...]
Read more