Investors often turn to exchange-traded funds (ETFs) for their tax efficiency, but how exactly are capital gains from the underlying positions within an ETF handled? Specifically, what happens when an ETF removes one of its underlying assets, such as Microsoft (MSFT), and replaces it with another, like Intel (INTC)? Does this trigger a taxable event for the holders of this ETF? And how does this compare to mutual funds? Let’s dive into the mechanisms behind ETFs, the creation-in-kind process, and their implications for realized capital gains. The Tax Efficiency of ETFs One of the key selling points of ETFs is their inherent tax efficiency, which stems primarily from the creation and redemption process. Unlike mutual funds, where managers buy and sell shares directly within the fund, ETFs operate through a system involving “authorized participants” (APs). 1. Creation-In-Kind Process: When new shares of an ETF are created, APs deliver a basket of underlying securities to the fund in exchange for ETF shares. Conversely, when ETF shares are redeemed, the fund delivers the underlying securities back to the AP rather than selling them, so only the seller