Years ago, when I was first investing in mutual funds, I was shocked to find out that I’d be taxed on any capital gains made by the fund, as well as any capital gains I made by selling shares that had gone up in value. ETFs get around that problem:
Exchange traded funds (ETFs) are an increasingly popular investment. ETFs are open-end mutual funds that, unlike traditional open-end funds, trade on exchanges, such as the NYSE and AMEX. The fact that they can be bought or sold throughout the day is one of their advantages over ordinary open-end funds, which only allow purchases and sales at the end of the day.
But the big advantage of ETFs is that the sale of securities inside the fund does not typically generate taxable capital gains for ETF shareholders.
In Keep It Simple, finance luminaries Fama and French argue to treat all mutual funds like ETFs:
We suggest a simplification of the tax code that levels the playing field for ETFs and ordinary funds. Taxation of distributed dividends continues. (It hits the shareholders of ETFs and ordinary funds in the same way.) But taxation of capital gains occurs only when fund shareholders redeem their shares. In other words, we suggest that mutual fund capital gains should be taxed in the same way as gains on other securities. This is the system in many other countries.