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Tax Efficiency

As we have seen, mutual funds have a potentially large disadvantage when it comes to taxable distributions. The investor has no control over what the fund will distribute in a particular year, and therefore can face a large tax bill on the distributions. The year 2000 is now famous, or infamous, for just such events. Many mutual fund managers took some gains early in the year following the great market years of the late 1990s, and then when the market declined and the funds had to sell shares to pay redeeming shareholders, still more taxable distributions were realized.

ETF investors are protected, but perhaps not as much as many assume. They definitely are protected from redemption gains. Mutual funds, including index funds, are vulnerable to investors leaving the fund in sufficient numbers that the fund manager must sell portfolio positions to buy back shares of departing investors. Because of the unique redemption feature of ETFs, they are able to avoid such transactions.


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