Why ETF is Tax Efficient as Opposed to Mutual Funds

Because most ETFs are mutual funds, you are also subject to many of the tax liabilities that apply to mutual funds. That is, when a fund is forced to sell stock to change its composition, for example, when an index rebalances, the fundholders have to pay capital gains on whatever the gain was of the stock that is sold. Here's where it gets tricky, though. ETFs have the potential to make that gain smaller than it might be in a traditional mutual fund. How? Simple. Because ETFs are created and redeemed with stock that is traded in-kind, it is possible to raise the overall cost-basis of the stock that underlies the fund. Whenever a basket of stock is redeemed, the fund gives the redeemer the lowest cost-basis underlying stock. It doesn't matter to the redeemer. He pays based on his individual cost-basis regardless. The net result is that the fund is holding higher cost-basis stock, making the exposure to capital gains less when a particular stock must be sold in rebalancing.