In all of my years of investing, I have never seen a vehicle as tax efficient as exchange-traded funds (ETFs), particularly when they are held in a thoughtful portfolio and regularly rebalanced.

ETFs in many instances are more tax efficient than mutual funds and individual stock holdings, and you owe it to your heirs — if not yourself — to understand why.

Here's how it works: Imagine a typical baby boomer investor who has been buying and holding blue-chips stocks for decades. What is in that person's portfolio after 30 years of large-cap stock investing?

Most likely, a large collection of highly appreciated stocks. A few might have gone by the wayside, to mergers, buyouts or bankruptcy, but most of the major names are probably intact and quite valuable.

Yet our long-term investor is stuck when it comes to taxes. He or she is collecting a nice steady dividend, perhaps, but selling is out of the question. Stocks that were bought at a basis of $5 years ago are now worth $120 or more. And the price keeps going up.

Free cash

It's a great outcome, don't get me wrong. But now the capital gains taxes on that portfolio are horrendous. Our boomer investor cannot sell and won't sell. Not for living expenses, not for emergencies or health care. It's too high a price. Effectively, the dividend income is all that matters.

Now imagine a typical mutual fund. The managers have dozens of positions and they trade them regularly. The taxes that pile up in that process. There might be some tax management going on inside the fund, but selling appreciated positions means taxes. The cost, paid by investors, can be stunning.

Can the active manager give you enough additional, above-market return to compensate? Rarely. But active mutual fund investing is, by definition, active. Those managers are always going to be selling something to buy something else they find more attractive, and that generates taxes paid one way or another by the investor.

Now, picture a robust portfolio of ETFs. Once you get into the asset classes you deem relevant to your goals, you never need to sell. Yes, you rebalance, but here's the trick: Free cash from incoming dividends is used to buy positions and when you have to sell, you sell recently bought positions first.

Say you own shares in a large-cap ETF in your retirement portfolio valued at $100 a share. The fund owns hundreds of stocks but it's just one ticker with one price. Dividends from the underlying stocks pour in. When you rebalance, you use dividend cash to buy more of the same ETF as it appreciates — first at $110 a share, then $112, then $115 and so on over the months.

Taxes and returns

As the price rises for that ETF you increase your position incrementally. Say you need to rebalance and it makes sense to sell some of that large-cap position. Which shares do you sell? Following the rule of "last in, first out" you start with any dividend cash that is uninvested. Then you sell, if necessary, only the most recently purchased shares of that same large-cap ETF.

Since you likely just bought those shares, chances are they haven't appreciated by very much. As a result, your capital gains hit is zero (on the cash) or very close to zero (on the shares).

Meanwhile, trading commissions on most index-style ETFs are zero, and while ETFs have fees, they are minimal, too, and far less than the fees charged by mutual funds.

In theory, all of your positions might decline relative to each other, leading to a rebalancing of positions that show losses. Yet the long-term experience with portfolio investing is of asset classes moving in opposite directions, not in unison.

Likewise, critics contend to holding ETFs for long periods is a mistake. That’s true if you invest in certain leveraged funds and commodity funds, perhaps, but an index-style ETF still makes sense for the buy-and-hold investor. Costs are minimized, taxes are controlled internally and you have none of the ongoing costs presented by active management.

Every dollar you don't give up in taxes stays in your portfolio, growing for you. ETFs already are inexpensive to own, but those saved tax dollars will supercharge your return by compounding over decades to come.

Yes, tax-loss harvesting is a nifty trick, but simply creating a portfolio of inexpensive ETFs and rebalancing can be a better way to retire with more, in part through superior tax efficiency.