A fund is a basket of stocks anly managed. The mutual fund manager needs to buy and sell investments in order to ensure that:
- The mutual funds mix of investments meets it’s objectives (i.e. balanced funds, dividend income funds, U.S. equity funds),
- It can meet it’s daily redemptions, and
- It invests new cash from investors.
The active management and need to sell to meet investor redemptions means that mutual funds will eventually incur capital gains and must distribute these to it’s unitholder’s.
Why ETF’s Are More Tax Efficient?
An ETF, or exchange traded fund, is a mutual fund of a different kind. The fund manager of an Index ETF buys a basket of socks to mirror the stocks of a particular stock exchange. Since ETF’s are closed to new investment and the stock index itself changes infrequently, there is less turnover than a regular mutual fund and less change the ETF will realize capital gains.
Note that I said that ETF’s are closed funds. This simply means that the way to invest in ETF’s is to buy them on an exchange as opposed to directly from the mutual fund company.