Taxes and Costs in Exchange-Traded Funds

Taxes

Exchange-traded funds are also structured to shield investors from capital gains better than conventional funds. Most ETFs are index funds, so they typically trade less than most 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--thereby triggering capital gains—to meet investor redemptions. Moreover, because the big institutions can make share 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.

Costs

Because exchange-traded funds don't have to manage hundreds of customer accounts or staff call centers, they have lower overhead charges that translate into lower expense ratios. However, you will pay brokerage commissions to buy and sell ETF shares, and the costs of rapid—or even occasional—trading can more than offset the initial advantage of an ETF's lower expense ratio. For those reasons, an ETF will be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For others, an exchange-traded fund may not have a big cost advantage over a plain-vanilla, low-cost index fund.