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Not a Pretty Market Close—Here's Why

Simon Smith | Vetta | Getty Images

Today's trading: It was not a pretty close. A wave of sell orders dropped us to the lows of the day right at the close.

Anxiety on fiscal cliff remains, but worry is not off the charts.

(Read more: S&P Falls 1% on 'Fiscal Cliff' Fears; Apple Drops)

Sectors thought to be negatively affected by an Obama second term (defense, coal, dividend payers) were down again today, but not as much as yesterday and on not as much volume.

(Read more: Obama's To-Do List)

There is plenty of anger — and some outright selling — on concerns over higher taxes in general, like this email from a trader friend:

"Calif. raise their state taxes on high earners RETROACTOVE to Jan??? think about that. RETROACTIVE tax increases?? thats not a good sign. how will we ever get spending problem and entitlement problem under control when the current admin. doesnt even see that as the problem..."

(Read more: Why US Economy May Be Headed for Another Recession)

I hear a lot about capital gains tax increases from traders. I continue to see weakness in some high-beta names (Apple ) that suggest traders are concerned about protecting the gains they have made this year and are trying to dodge headline risks associated with the fiscal cliff.

But do I see a total freak-out? I do not.

I've been watching the Volatility Index (VIX) and futures on the Volatility Index carefully for the last two days for signs that traders are freaking out over the fiscal cliff. If they thought we were going over, they would have rushed to buy protection. The VIX would have spiked — I mean really spiked, like going from 18 to 25 or higher. It has not. It closed at 18.49.

To put this in perspective, when the debate on the debt ceiling exploded in August 2011, and the S&P downgraded U.S. debt, traders went ballistic: the VIX went almost to 50, rivaled only by the spike in volatility during the May 2010 Flash Crash and after the Lehman collapse.

My point? There's worry, but people aren't jumping out windows.

Could ETFs benefit from "fiscal cliff anxiety?" Some are looking at alternative investments, like Exchange Traded Funds (ETFs). Why?

There is already some normal, end-of-year movement of ETFs that is happening. But there's an factor this year: ETFs almost never distribute capital gains, and with anxiety about capital gains tax increases growing, that is a big plus.

There are two types of capital gains: 1) capital gains from buying and selling in a portfolio, and 2) capital gains from selling your individual position in a stock, mutual fund, or ETF.

Most ETFs never distribute capital gains from buying and selling in the portfolio because 1) most are not actively managed, so there is relatively little buying and selling within the funds, and 2) ETFs have a more tax efficient structure due to the way shares are created and redeemed.

In an actively traded mutual fund, if I sell $10,000 of that fund back to the fund, the fund has to go and sell the underlying stocks in that fund, and that creates a taxable event for me.

In an ETF, there is no taxable event from buying and selling the underlying portfolio. If I want to sell $10,000 of an ETF, I can do it by selling to my broker. It may be bought by another natural buyer, or by a market maker. The market maker will go to the ETF fund itself and delivers those shares, and the fund in return will give the underlying stocks back to the market maker. That does not trigger a capital gain.

Come year end, the ETF and its shareholders will not owe any taxes due a distribution of capital gains. There will be a capital gain from selling my position, but I won't get a separate bill on capital gains distributions.

Get it? It's a more efficient tax structure. That's why ETFs make more sense for many investors.

Here's the data on equity ETFs, from Index Universe,

1) Only 20 of 756 equity ETFs paid distributions—less than 3% of all equity ETFs, and again, the gains they did pay out were tiny.

2) By comparison, 24 percent of equity mutual fund share classes made a capital gains distribution.

I'm not expecting everyone to go out and sell their mutual funds to buy ETFs. That wouldn't make much sense.

But I do think that a lot of new capital will continue to flow into ETFs.

—By CNBC's Bob Pisani

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  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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