Mutual Funds or Exchange-Traded Funds? Considering Taxes

Exchange-traded funds are structured to shield investors from capital gains better than conventional funds. First of all, since most ETFs are index funds, they typically trade less than actively managed funds and should generate fewer taxable capital gains. Also, because most investors buy and sell ETF shares with other investors on an exchange, the ETF manager doesn't have to worry about selling holdings directly—thereby triggering capital gains—to meet investor redemptions. Rather, institutions called "authorized participants" can make share creations and redemptions "in-kind" (rather than redeem shares for cash, the ETF gives the institution a basket of stocks equal in value to the share redemption), ETFs can unload their lowest-cost-basis stocks in the portfolio, thereby reducing their capital gains exposure.