Taxes and ETFs

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djs051085
Posts: 7
Joined: Thu Jun 27, 2013 2:05 pm

Taxes and ETFs

Post by djs051085 »

So... If I buy and hold a mutual fund, I will periodically get hit with a tax obligation despite the fact that I have not bought or sold shares. Essentially, when the fund needs cash for redemptions, rebalances or reconstitutes their underlying holdings the capital gains burden is passed to the investor.

I understand that ETFs are traded "in kind" (at least this is the phrase I keep seeing), which, I believe means that the underlying shares are traded directly when the ETF share is bought or sold. But my question is what happens if the fund rebalances or reconstitutes. For example, RSP is an ETF that tracks the equally-weighted S&P 500. So, for argument's sake let's say a share is trading at $50 a share. There are 500 companies, equally-weighted, so this is equivalent to buying $0.10 of each underlying company. As the underlying share prices change, the ETF deviates from equal-weighting. Doesn't the ETF manager need to rebalance the fund to maintain that equal-weight at some point? Doesn't the sale of underlying shares generate capital gains? Are these taxes deducted from the share price directly? I know they are not passed to the ETF share owner directly.

Any ideas?
livesoft
Posts: 85971
Joined: Thu Mar 01, 2007 7:00 pm

Re: Taxes and ETFs

Post by livesoft »

I think all one can do is to research the historical distributions of the ETF in question to see what to expect in the future. Even so, one has to be prepared for surprises.

In any event, ETFs pay dividends and some of them pay capital gains distributions as one can see from the historical records.
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