Q: I have a question on an exchange-traded fund. I'm basically a buy-and-hold investor in retail mutual funds. But as you know, panicky selling hurts existing shareholders. Are ETFs less likely to see portfolio disruption by shareholder redemption? Why?
A: Yes, they are less likely to suffer, for three reasons: One, they tend not to attract market timers to the same extent that retail mutual funds do, so there is less likelihood of trading in that regard; two, they have very low turnover themselves, which means they are not as likely to be subject to style drift or bracket creep because some fund manager is trading heavily; three, due to the way many ETFs handle their tax reporting, they are able to offset one investor's selling with another's buying -- enabling the fund to avoid reporting the transactions as capital gains or losses.
This explains why the typical exchange-traded fund often issues capital gains distributions that are dramatically lower than those offered by typical retail mutual funds.