Tax Advantages of Exchange-Traded Funds

Investment risk can be minimized by diversifying portfolio selections. Mutual funds are considered an effective vehicle to achieve this goal: one share of a mutual fund can represent the ownership of the entire market. However, mutual funds may suffer from a serious disadvantage in terms of capital gain distribution: mutual-fund investors may end up with a heavy tax burden. Exchange-traded funds (ETFs), which came about in 1993 with the launch of the Standard & Poor’s 500 Trust Series 1 (SPDR 500, ticker symbol: SPY), were created to offer not only the same diversification and convenience presented by mutual funds but also to alleviate the tax burden on investors. In this chapter we examine why mutual funds present such a disadvantage in relation to ETFs, by reviewing the relevant tax laws and how ETFs operate to produce the significant tax savings reported by their sponsors. In the next chapter, we put these claims to the test, comparing the actual tax distributions of selected ETFs to those reported by their direct mutualfund counterparts, to determine whether there are tax advantages to report.