The tax efficiency of exchange-traded funds is usually explained by saying they don’t have to sell securities to meet redemptions. That’s true and it’s only half the mechanism.

The other half is a specific provision in US tax law exempting in-kind distributions of appreciated securities to redeeming shareholders. That exemption is what allows a fund to hand over holdings rather than cash, and it’s the foundation the structural advantage rests on.

Because the provision is specific rather than incidental, it can be used deliberately, and how deliberately is the subject of an active argument.

Where the Structure Shows Up for a Holder

Answering what is an ETF usually covers trading, cost and diversification. The structural tax point sits underneath all three and only becomes visible at year end.

For a holder in a taxable account, the practical consequences are:

  • Fewer capital gains distributions, since redemptions don’t force sales
  • More control over timing, as gains are largely realised when the holder sells
  • Lower embedded unrealised gains carried inside the fund over time
  • No benefit at all inside a tax-sheltered wrapper, where distributions aren’t taxed anyway

The rules described here are US provisions. Other jurisdictions have their own treatment, and the structural mechanics transfer more reliably than the tax outcomes do.

What Custom Baskets Allow

The mechanism becomes more powerful when the fund can choose what to hand over.

Legal analysis of the provision explains that funds and authorised participants work together in so-called heartbeat trades, in which an ETF distributes shares of a specific company to a redeeming participant instead of a pro rata basket of the portfolio, with the distributed securities being appreciated shares of companies on the verge of being acquired in a taxable transaction or slated for removal from the index, where in the absence of such trades the fund would recognise gain from selling the shares.

The same analysis notes the underlying logic: distributing low-basis securities minimises the fund’s unrealised gains, whereas selling high-basis securities to avoid recognising gains would leave the low-basis holdings in place and increase the embedded gain the fund carries.

So the redemption process isn’t only neutral on tax. Used with discretion over which lots to deliver, it actively improves the fund’s cost basis over time.

What Changed After 2019

This capability was not evenly available, and a rule change altered who could use it.

Research examining the effect found that a 2019 rule standardising fund operations provided all ETFs with the ability to issue custom baskets, which are baskets not composed of a pro rata representation of holdings, and that there has been a substantial increase in heartbeat trades since the rule took effect, with the increase much larger among funds that were only able to use custom baskets afterwards.

That’s a clean natural experiment. Funds granted a new capability used it, and the increase concentrated precisely among the newly enabled group.

For a holder, the implication is that the structural advantage isn’t uniform across funds. It depends partly on whether a given fund uses custom baskets and how actively.

Where the Advantage Doesn’t Reach

Being precise about the limits matters more than the headline:

  • Tax-sheltered accounts gain nothing from this, since the distributions weren’t taxable
  • Bond funds benefit less, because interest is taxed as income regardless of wrapper
  • Some emerging market funds face restrictions on in-kind delivery
  • Derivative-based products can’t deliver holdings in kind at all
  • Dividends are taxable to the holder whatever the structure
  • Non-US investors face entirely different rules

The first point is the one most often missed. A holder whose entire portfolio sits inside a pension or similar wrapper can disregard this discussion completely.

The Debate About Whether It Should Exist

The practice attracts criticism, and the criticism is worth knowing rather than dismissing.

The argument against is that a provision designed to prevent an administrative problem has become a systematic tax-deferral tool, applied at scale, available to one fund structure and not another that holds identical securities. The legal literature includes explicit proposals to reform it.

The counterargument is that the deferral isn’t permanent. Gains are still taxed when the holder sells, so the effect is timing rather than exemption, and the timing benefit accrues to ordinary shareholders rather than to the fund.

Both readings are held by serious people. What matters practically is that the rules could change, and a structural advantage resting on a specific statutory provision is less permanent than one resting on economics.

What a Holder Should Take From This

The advantage is real, it’s larger in taxable accounts held for long periods, and it varies by fund type and by how the manager operates.

None of that argues for choosing a fund on tax structure alone. It argues for knowing which part of a fund’s appeal comes from what it holds and which part comes from how it’s built, since only one of those is inside the manager’s control and only one depends on a rule staying as it is.