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ETF (Exchange-Traded Fund)

What is an ETF (Exchange-Traded Fund)?

ETFs (or exchange-traded funds) are hybrid investment vehicles that can offer relatively low-cost and tax-efficient exposure to a variety of asset classes and investment strategies. Like traditional mutual funds, most ETFs invest in a diversified portfolio of stocks and bonds. Unlike traditional mutual funds, ETFs trade on a stock exchange. 

The majority of ETFs are passively managed, which means they track an index. That said, a growing minority of them are actively managed. Irrespective of whether they are tracking an index or delivering an active strategy, ETFs tend to have lower annual expenses relative to mutual funds. That said, because they trade like stocks, investors should account for transaction costs (commissions, bid-ask spreads, and so on).  

ETFs are often lauded for their tax efficiency compared with traditional mutual funds. There are two main reasons ETFs are often more tax-efficient. First, most ETFs are index funds. And index funds, especially large-cap index funds or total-market index funds that are weighted by market cap, have fairly low turnover. Low turnover means fewer opportunities to realize gains when securities are sold from the portfolio. ETFs' structure is the second, more important driver of their tax efficiency. ETF shares are created and destroyed via in-kind transactions between ETFs' sponsors and a special kind of market maker known as an authorized participant. As such, ETFs tend not to have to directly sell positions from their portfolios to meet redemptions, which protects investors from taxable capital gains distributions. 

Investors should be aware that tax-efficient doesn't mean tax-free, though. The primary benefit of ETFs from a tax perspective is that they can allow investors to defer the realization of capital gains taxes. Investors in ETFs will still pay taxes on regular distributions of income, and they will also pay capital gains taxes when they sell an ETF for more than they paid for it. Also, some ETFs will distribute capital gains, though they tend to be less frequent and of lesser magnitude than those their mutual fund counterparts generate. 

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