I don’t seem to understand the differences between ETFs and indexed mutual funds. And especially how they differ in terms of redemption and tax/cost perspective. Can someone briefly explain?
ETFs can be traded like stock , and you can borrow and short it too.Not with mutual funds.
ETFs buy stock shares from market makers who in turn receive shares of the ETF . The market makers can then distribute the ETFs shares in the market for a profit . Depending on demand and supply , the NAV of the ETF may differ from the calculated value of a share , so the market makers can arb in between. (e.g. if the NAV of the fund is much lower or higher than the fair value of the assets , they can buy or sell the NAV and exchange creation units with the ETF and make an arb profit )
The arb process works throughout the day when the exchanges trades. Whener the NAV of the ETF differs significantly from the calculated NAV from the shares of stocks held , the market makers can buy or sell creation units by supplying shares of stocks or taking them away .
ETFs never sell their shares either , if redemptions occur , they just return the shares that the shareholder holds to the market makers, who bear the risk. So the fund itself suffers fewer capital gain events and is more tax efficient as a result.So if you are a shareholder in the ETF who sells his shares , you get capital gain tax hit , but the ETF merely creates a “creation unit” and sells it for shares of company stocks to an authorised participant. . It is this risk taker that actually sells the shares in the market to return cash to the shareholder.
One more thing…ETF are redeemed in kind - no tax event where as redemption with Indexed Mutual Funds create tax event.