Exchange-Traded Funds: A New Investment Option for Taxable Investors

Exchange-traded funds (ETFs) are a rapidly growing class of financial products. Exchange-traded funds are of interest to public-finance researchers concerned with taxation and portfolio behavior for two reasons. First, they represent financial innovations that are sometimes described as prototypes for the future evolution of the mutual fund industry. Second, ETFs are often promoted as being more "tax efficient: than traditional equity mutual funds. The pretax and after-tax return on the largest exchange-traded fund, the SPDR trust, which holds the securities in the S&P 500, are compared with the Vanguard Index 5000 fund. Exchange-traded funds are technically mutual funds, so they are governed by the same tax rules, but they have used a technique known as "redemption in kind" to reduce substantially or even eliminate their distributions of realized capital gains.