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In-Kind Redemption for ETFs

For ETFs, in-kind redemptions are the primary mechanism by which redemptions are made. When an investor wants to redeem ETF shares, the distributor usually exchanges the shares to be redeemed for a basket of securities held by the ETF. Only “authorized participants” – a form of institutional investor – may redeem shares directly from an ETF. These investors are also able to contribute securities to a fund in exchange for newly issued ETF shares. Retail investors, on the other hand, can only buy and sell ETFshares through a broker.

ETF distributions are set up this way to maximize tax efficiency and minimize capital gains distributions. According to KPMG, in-kind redemptions create “more opportunities for ETFs with appreciated and liquid portfolio holdings to defer gain recognition.”

In all cases where ETFs make in-kind redemptions, the fund never has to sell securities to generate cash. As such, it avoids generating taxable gains for non-redeeming shareholders. ETFs can also use this redemption mechanism to remove capital gains and permit non-redeeming shareholders to defer taxes on their gains.

Check out this article to learn how ETFs were made for tax-loss harvesting.

Regardless of the redemption options available to ETF managers, the in-kind mechanism proves to be more attractive in a variety of circumstances. Since many ETFs employ passive index strategies, they usually have lower turnover than actively managed funds. If a passive ETF sold securities to meet redemptions, it would create a large taxable event for non-redeeming shareholders.

The redemption mechanism is also useful when we consider investor behavior. Since investors buy ETFshares on a cost-average basis, they would be sold or redeemed for a higher amount than the cost basis. Once again, this means higher tax payments on that sale.