Why are ETFs more tax-efficient?

NEW YORK (CNN/Money) -- Question: I've been reading about Exchange Traded Funds (ETFs), but don't understand why ETFs are supposed to be more tax efficient when investors redeem shares. Doesn't the ETF manager have to sell securities to pay departing shareholders the same as a mutual fund manager does? And if those selling those shares results in a net realized capital gain wouldn't that mean the ETF would has to pass along that taxable gains to shareholders just like a mutual fund? -- reader in Illinois

Answer: Your question gets to the fundamental difference between ETFs and mutual funds. As I explain in a series of articles in our ETF Center, ETFs trade on an exchange like stocks, which means you're typically buying shares from an investor who already owns them or selling shares you own to an investor who wants to own ETFs.

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In such cases, the ETF doesn't get involved in the transaction at all, which means a sale of ETF shares wouldn't result in the ETF itself having to sell securities at all. No sale of securities, no capital gain to pass along to existing ETF investors.

Sometimes, however, there may not be enough existing shareholders willing to sell shares to wannabe ETF investors -- or enough wannabe ETF investors to buy shares from ETF shareholders who want to sell. At such times, there's a unique process for creating and redeeming shares without triggering tax consequences.

To create new shares, a brokerage firm or institutional investor buys a basket of securities that exactly mirrors the holdings of the ETF. That firm then gives the securities to the ETF in return for new shares of the ETF.

To redeem shares, the process works in reverse. The brokerage firm presents ETF shares to the ETF in return for a basket of securities from the ETF equal to the value of the ETF shares. The firm then sells those securities in the market for cash that goes to redeeming investors.

Since the ETF itself only exchanges shares for securities in the case of a redemption -- as opposed to actually selling the securities as a mutual fund does -- the transaction doesn't generate a taxable distributions for shareholders. This process gives ETFs an advantage when it comes to tax efficiency.

Keep in mind, though, that ETFs can still sometimes generate taxable gains. If the index they track drops some stocks and adds others, then they must sell shares of the stocks that have been jettisoned from the index, which can result in capital gains distributions to shareholders, although there are also techniques for minimizing gains in such situations.

This process also helps ETFs stay in synch with their indexes, although they can still stray. To get an idea of how tightly an ETF tracks its index, you can go to Morningstar.com, plug the ETF's ticker symbol into the Quotes/Reports box and then check out the Key Stats section of the Snapshot page. The Total Return section also compares returns based on the ETF's net asset value and the ETF's market trading price.

The extent to which this unique method for creating and redeeming shares translates to an after-tax performance edge, however, depending on such factors as the expenses of a particular ETF vs. a similar index mutual fund, how often stocks move in and out of the index, the brokerage commissions and other transaction costs involved in buying ETFs, the size of the investment you make and how long you hold that investment.

I can tell you that this ETF-vs. Index Funds debate can get very complicated and esoteric. If you're into that sort of thing, though, you can click here, here and here to really get into it.

Generally, though, I'd say that if you are investing large sums of money (say, $10,000 or more) and keeping that money invested for the long-term (at least 5 years, preferably more), ETFs based on the more popular benchmarks such as the Standard & Poor's 500, the Nasdaq 100 and indexes that track the entire U.S. stock market (such as the Dow Jones Total Market Index) stand a good chance of delivering better performance, although I don't think the difference is enough for people who invest in index mutual funds to stay up nights worrying about.

If you tend to dollar-cost-average or invest smaller amounts periodically, then index mutual funds are probably a better bet. Otherwise, you may incur brokerage costs that can erode or wipe out any advantage ETFs might otherwise have.

Finally, let's not forget to keep this in perspective. If you're investing for the long-term using low-cost options like ETFs and index mutual funds, you're likely to do better than those investors who chase whatever funds happen to be on this year's top-performer lists and who buy high-cost funds in the mistaken belief that highly paid managers and fund companies will outperform.

So while fund fanatics might get all hyped up about whether ETFs or index mutual funds are the best choice, my feeling is that you can do quite well in either one and much better than in most of the other choices out there.

Visit the CNN/Money ETF Center by clicking here.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "We're Not in Kansas Anymore: Strategies for Retiring Rich in a Totally Changed World."