Canadian Securities Course (CSC) Level 2 Practice Exam

Which factor is crucial for tax efficiency in ETF investing?

1. High dividend reinvestment

2. Low risk portfolio

3. Low turnover

4. Active trading strategies

The correct answer is: Low turnover

The focus on low turnover as a crucial factor for tax efficiency in ETF investing is well-founded. Low turnover means that the fund managers are not frequently buying and selling securities within the ETF. This is significant because frequent trading can trigger capital gains distributions. When these gains are passed on to investors, they are subject to taxation in the year they are realized, reducing the overall after-tax returns for investors. In contrast, ETFs that maintain a low turnover generally have fewer transactions, which minimizes taxable events. As a result, investors can benefit from a more tax-efficient investment strategy, allowing their capital to grow longer without incurring immediate tax liabilities. Other factors, such as high dividend reinvestment, do not directly influence the tax efficiency of ETF investing. While having dividends that are reinvested can be beneficial for growth, they can also create taxable income if not managed properly. A low-risk portfolio does not necessarily equate to tax efficiency—it can include a variety of turnover levels. Active trading strategies often lead to higher turnover, thereby increasing potential tax liabilities through realized capital gains.