There are many benefits when it comes to investing in an ETF, such as transparency, intra-day liquidity, tax efficiency and etc. Tax efficiency is a big one and not many people may know the inner workings of an ETF to understand why an ETF is more tax-efficient than a mutual fund.

This article is set to explain how ETFs managed to be more tax-efficient than mutual funds from an operational/trading process called ‘heartbeat trades’.

When a fund sells a stock that has appreciated in value, this will trigger a capital gain tax bill for its shareholders.

However, the fund can avoid the tax bill by artificially creating a redemption and use appreciated stocks to settle the redemption. This process of using appreciated stocks to settle the artificially created redemption does not create any tax bill under the US tax codes. This is known as an in-kind redemption.