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My understanding is that an ETF is a basket of a variety of stocks.

When that basket is rebalanced and some stocks are sold and others are bought, won't that result in a profit/loss in the same way selling off an individual stock would.

Does that result in taxable gains, every time the ETF is rebalanced, even though the ETF itself hasn't been sold?

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ETFs have the ability to execute a custom in-kind redemption rather sell securities, allowing them to avoid generating capital gains if investors redeems shares or if the fund rebalances.

The manager offloads the shares that he wants to sell to an Authorized Participant. The AP buys the shares that the ETF manager wants to own (an equal dollar amount) and returns them to the fund via an in-kind creation. The fund now owns the correct securities and has avoided a cash transaction from selling the shares.

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  • So the AP goes and swaps the share A for equal dollar amount of Share B, thus avoiding selling Share A then buying Share B. And there are no associated fees with this?
    – Darren rogers
    Commented Jan 15, 2019 at 0:54
  • There are fees involved because there are transactional costs and the AP doesn't work for free. But those are operational costs which aren't tax issues that you alluded to. I wouldn't say that this process is categorically true in all cases since leveraged and inverse ETFs are bit complex structurally and I surmise that they may not be cookie cutter simple like mimicking an index. But that's just a guess on my part.
    – Bob Baerker
    Commented Jan 15, 2019 at 1:10
  • @BobBaerker Can you provide a cite that in-kind creation or redemption can avoid a capital gain when exchanging one security for another (altering the ETF's portfolio), as opposed to the standard case of exchanging shares of the ETF itself for the portfolio basket? The latter is the usual role of authorized participants; I haven't seen the former.
    – nanoman
    Commented Feb 14, 2019 at 2:00
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A key point is that standard ETFs rarely have a need to rebalance. They typically track indexes with reasonably fixed share-based weightings (capitalization-weighted or price-weighted). Yes, the index composition changes a little as stocks are added and dropped over time, but this is usually a minor amount of the portfolio. And when the adjustment is due to a merger, acquisition, or spinoff, that is typically a tax-free swap as it would be for an individual holding the stocks directly.

The in-kind exchange via authorized participants (APs) that Bob Baerker mentions is about allowing the ETF to shrink its holdings when people sell, without selling its holdings (and incurring the associated gain that would have to be distributed to remaining ETF holders). As the ETF market price sags, an AP will redeem ETF shares and receive the portfolio basket; those stocks leave the ETF and any taxable gain on them disappears. But I think the basket has to reflect the current composition of the ETF, and an AP can't be given just the stocks the ETF wants to get rid of tax-free.

As far as I know, when rebalancing (changing the composition of the ETF) does occur, realized gains are taxable. Such rebalancing would be more common in ETFs that do not have a simple 100% long portfolio.

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