One who is invested in the exchange-traded funds (ETFs) either talks about its benefits or the risks associated with it. But, most people are not aware of benefits and only worried of risks like market risk, tax risks, counterparty risk, shutdown risk, and trading risk but only a few people know that there are benefits which can null most of the risks in ETFs. That’s why we are going to discuss the two of the most underappreciated benefits of ETFs – Transparency & Tax Efficiency, which make exchange-traded funds (ETFs) light years ahead in two specialized areas.
As you know that an ETF or exchange-traded fund is a marketable security (liquid financial instrument) that follows an index, a stock, a commodity, or a basket of assets like an index fund. Unlike mutual funds (MFs) an ETF trades like a common stock on a stock exchange thus it does not have its net asset value (NAV) calculated once at the end of every day.
Its better transparency is the #1 reason for becoming so popular among investors as compared to competing for mutual funds. Unlike mutual funds, that are only required to disclose their portfolios on a quarterly basis, ETFs are far more transparent and most of them disclose their full portfolios on public and regularly updated portfolios on online platforms which anyone can see any time of the year. In fact, all “actively managed” exchange-traded funds must, by law, disclose their full portfolios on daily basis. This makes ETFs more transparent than any mutual fund or other marketable security.
Exchange traded funds (ETFs) are almost always more tax efficient than mutual funds. And the reason for that is “Interaction”.
Most exchange-traded funds have a very little turnover and thus collect far fewer capital gains than an actively managed MF. But, they are also more tax efficient than index mutual funds. So, if an MF investor asks for his/her money back, the mutual fund sells securities to raise cash to come across that redemption but when an investor wants to sell an ETF, he/she can simply sell it to another investor just like a stock. When the authorized participant redeems shares, the ETF issuer instead of rushing out to sell stocks can simply pay the AP “in kind” – delivering the underlying holdings of the ETF itself.
Also, the ETF issuer has the facility to choose which shares to give to the authorized participant. If one wants to hand off shares with the lowest tax basis then one can do that. In doing so, this leaves the ETF issuer with shares purchased at or above the market price.
The result, the pressure of a fund’s tax will be less and after-tax returns will be higher.
Final thoughts: –
By discussing the two most underappreciated benefits of exchange-traded funds, it is clear that exchange-traded funds have better transparency and tax efficiency among other funds structure in the market. However, the fixed-income ETFs are not that tax efficient due to more turnover and cash-based redemptions and creations.