ETFs handing investors big capital gains -- to pay taxes on

Only a few people really care, but there's a mutual fund battle raging: Are exchange-traded funds superior to traditional mutual funds, or should investors stick with the classics?

According (subscription required) to the Wall Street Journal, a lot of ETFs will be distributing large amounts of capital gains to investors this year -- and they'll have to pay taxes on them. The bull market of the past few years has left a lot of funds, traditional mutual funds as well as ETFs, with capital gains.

But ETFs remain for tax efficient than most traditional mutual funds, in part because most ETFs seek to mimic the performance of indexes, and trade very infrequently. Vanguard appears to be the leader in tax-efficient ETFs, and won't be making any capital gains distributions on any of its ETFs this year.

But there are other costs associated with ETFs that investors need to consider: Because they're traded on exchanges, you have to pay a commission each time you buy or sell shares of an ETF. If you're trading in small dollar amounts, those can eat up a significant chunk of your investment. In addition, the ease with which they can be traded can encourage hyper active trading which tends to lead to poor performance.

But for sheer tax efficiency, ETFs appear to be superior to traditional mutual funds.