Why are ETFs tax efficient?

ETFs gain their tax advantage primarily through the creation-redemption process. When investors buy or sell ETF shares, authorized participants exchange baskets of securities directly with the fund—transferring shares in-kind rather than selling them. This avoids triggering capital gains inside the fund, and so it becomes very unlikely that an ETF will distribute capital gains to ETF shareholders.

Now, ETFs still distribute ordinary income from dividends and interest, just like mutual funds. But they rarely pass through capital gains.

There's also a lesser-known strategy becoming more popular in recent years: seeding an ETF through a 351 exchange.

In a 351 exchange, investors can contribute appreciated securities at fund launch in a tax-deferred manner. This creates opportunities for tax-efficient diversification or adjustments to exposures.