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Understanding the Exchange Traded Fund (ETF) structure and its intrinsic tax benefits

by AOG Wealth Management

AOG clients’ portfolios have evolved over the last few years to include a sizable percentage of Exchange Traded Funds (ETFs). The ETF structure has proven to be very popular among investment professionals as ETFs continue to attract more investment inflows due to many of their benefits. The main benefits of ETFs over similar investment vehicles can be found in the ease of tradability (ETFs trade intra-day on exchanges); the very competitive lower fees associated with ETFs; the transparency of the ETF structure which specifies that all holdings be disclosed daily; the diversification that comes from the broader exposure within an ETF; and the tax benefits of an ETF when compared to mutual funds. The tax benefit, although often used as a promotional point, requires some deeper understanding to fully comprehend. The following overview of how an ETF is structured seeks to highlight where the tax benefit for the ETF investor originates and why this has become such a preferred substitute for traditional mutual funds.

The process of creating an ETF starts when an ETF Manager (known as a sponsor) files a plan with the exchange regulator to create an ETF. Once this plan has been approved, only authorised participants (generally market makers[1], specialists or large institutional investors) are permitted to create or redeem the ETF shares. Sponsors and authorised participants (AP) are frequently the same entity. To create the ETF shares, the authorised participant must deliver a collection of securities to the fund equal to the current holdings of the fund. After delivery has been made, the AP receives a large block of ETF shares (also known as creation units), representing a block of 10,000 to 600,000 ETF shares, with 50,000 being the typical size. This transfer of securities is done on an in-kind[2] basis and therefore has no tax implications.

The construction of the creation units represents the primary market in which ETF shares are traded. The AP can subsequently sell the ETF shares to other investors in the secondary market in smaller quantities. Utilizing this creation process, the bid for ETF shares can always be met, as APs can create additional shares on demand. New ETF shares can be created and sold into the secondary market when enough of the underlying assets that the ETF fund consist of have been accumulated and exchanged for creation units.

The opposite strategy, known as the redemption process, can also be followed when demand for the ETF shares are low and an over-supply exists in the market. The AP can buy enough ETF shares in the secondary market to form a creation unit. The creation unit may then be exchanged with the fund for the underlying securities that are represented by the creation unit. This option is generally only available to institutional investors due to the considerable number of shares required to form a creation unit. When the AP redeems their shares, the creation unit is destroyed and the securities are turned over to the redeemer. Smaller retail investors are limited to only selling the ETF shares in the secondary market. The ETF creation and redemption process helps keep ETF supply and demand in continual balance and provides a hidden layer of liquidity. The illustration below gives a visual breakdown of the processes.

The tax benefits for the individual ETF investor can be seen from the differences between the redemption process of an ETF and a mutual fund. The structure of a mutual fund is such that all investors are affected by the tax burden when a redemption takes place. When an investor redeems his/her shares in a mutual fund, the fund will have to sell some of the securities in the portfolio, realizing a capital gain and creating a tax liability. Regulation requires mutual funds to pay out all the dividends and capital gains on an annual basis. Should the scenario arise where a mutual fund has lost some value during a year (an unrealized capital loss), all redemptions during the year that were realized creates a tax liability to the investor as this had to be paid out.

In contrast, the in-kind redemptions made by ETFs allows the fund to exchange the shares with a lower cost basis with the redeemer, leaving securities in the fund which were acquired at a higher cost. This practice leaves the ETF’s overall cost basis at a higher level, reducing the capital gains to a minimum when redemptions take place. The gain or loss as realized by the redeemer when selling the shares in the secondary market (calculated from the purchase price and not the fund’s cost basis), does not impact the ETF. This is a great benefit of ETFs over mutual funds in the manner that smaller portfolios are unaffected by the tax implications that could result from the actions of investors with greater holdings in the fund.

As ETFs continue to evolve and cover more niche markets and alternative asset classes, previously inaccessible to the retail investor, investors will find it to be a worthwhile inclusion into their portfolio given the inherent benefits.

 

Overview of the Creation and Redemption Process:

creation and redemption process


[1] Market makers represent those firms willing to transact in both the buying and selling of a security. Acting in both capacities allow them to essentially create a market for that security.

[2] Securities are traded for securities.

 

This is neither an offer nor a solicitation to purchase any products, which may be done only with a current prospectus. Investors should consider their investment objectives and risks, along with the product’s charges and expenses before investing.

Past performance is not a guarantee of future results. All investments involve risks, including loss of principal.

Please submit all tax forms to your tax preparer for their review and evaluation.  Consult with your tax and/or legal advisor for tax guidance.  The opinions and views expressed here are for informational purposes only.  Please note that neither Kalos Capital nor any of its agents or representatives gives legal or tax advice.

The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you consult your accountant, tax, or legal advisor with regard to your individual situation.

 

Category: Investment Management, Wealth Management