Do buybacks force cap gains in index funds?

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djm2001
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Joined: Fri May 29, 2020 6:23 am

Do buybacks force cap gains in index funds?

Post by djm2001 »

It's often stated (e.g., on Wikipedia) that buybacks are a more flexible and tax-efficient method of distributing profits than dividends since the investor gets to choose when and how much gains should be realized (e.g., depending on their personal consumption needs). However, I'm wondering if this advantage starts to disappear if the investor holds cap-weighted index funds instead of holding the stock directly...

When a buyback happens, I would guess that the company buys back from sellers that are (mostly?) not the index fund itself. This would result in the index fund now having too much of the stock relative to the new market proportions, and would therefore need to sell some of the stock to rebalance to get back to market cap weights, which would trigger cap gains taxes for these non-dividend-paying stocks that are ultimately paid for by the index fund holders.

Do I understand this correctly? In particular, am I right in thinking that non-dividend-paying stock buybacks result in imbalance in an index fund due to imbalance between the proportion of shares sold inside vs outside the index fund, whereas dividend payouts don't result in imbalance because dividends are paid out to all shares equally, both inside and outside the index fund?

(Some of the forced sales can be avoided for popular index funds by rebalancing with inflow / outflow money, but that is not the point of my question.)

edit: I just found this thread that asks the question raised here and more or less answers it in the affirmative.
AA = global stocks & bonds @ market weight (~60/40); EF = i-bonds; WR = -PMT(1%, 100-age, 1, 0, 1)
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