That doesn't mean there is never any tax. ETF gains are reflected in the share price — basically, the assets in the ETF fund divided by the number of shares. As the value of assets like stocks rises, the share price goes up. When the investor sells her ETF shares, she will be taxed on the capital gain, the difference between the sales price and original purchase price. But this tax can be postponed for decades, and the investor is blessedly free from annual tax in the meantime, leaving more money in the account to compound.
Distributions by actively managed funds vary considerably, of course, but can be big. John M. Scherer, founder of Trinity Financial Planning in Middleton, Wisconsin, offers the example of American Funds Growth Fund of America (AGTHX), a large capitalization growth fund. It paid a $3.391 per-share long-term capital gains distribution last December, equal to 8.24 percent of the $41.12 share price, according to Morningstar, the fund-tracking firm.
Over the past 10 years the Growth Fund of America has slightly trailed the S&P 500, which also holds large-company stocks. So why not invest in the S&P 500 instead? The SPDR S&P 500 ETF (SPY), which tracks that index, had no capital gains distributions last year. Nor the year before. Or the year before that.
For most investors, the tax efficiency offered by ordinary index mutual funds is good enough. The granddaddy of index mutual funds, Vanguard 500 Index fund (VFINX), which also tracks the S&P 500, also had no capital gains distributions last year.
But since index funds, as opposed to ETFs, can in theory have distributions caused by redemptions, most experts give ETFs the tax-efficiency edge. And ETFs have some other benefits. Because they require little management, their fees, expressed in the expense ratio, are all but nonexistent. SPY charges a mere 0.09 percent a year, compared to 0.16 percent for VFINX and 0.65 percent for the Growth Fund of America, a fairly typical charge for an actively managed stock fund. That difference adds up over the years.