Good question. Is this being covered in CFA Exam I?
The question is really about comparing ETF's to traditional mutual funds. If you have owned mutual funds you have gotten a capital gains distribution at the end of the year. Since a mutual fund is a pass-through, when it buys stocks at 10 and sells them at 100 it passes the capital gains off to its investors. Further, it doesn't make a difference whether the mutual fund bought the stock in 1987 and you bought the mutual fund last week. You get the capital gains distribution. Ouch.
ETF's are constructed by some big bank (or similar) providing a ton of securities to the ETF. Small investors then buy shares of the ETF. That means there are two classes of investors - the big bank and everyone else. When the bank adds or redeems shares, it does it with "in-kind" transactions. That means that blocks of securities are exchanged rather than buying or selling securities. There is no taxable event in this. When any other investor buys or sells the ETF, they do it with another investor so the rest of the investors are unaffected by the transaction and there is no capital gains distributed to them.
There are even some other cool tax advantages of ETF's relating to constantly raising the basis through the "in-kind" transactions with the bank. Some of this flows through to tax advantages in forced redemptions of securities in corporate actions and the like.
If you have tax problems but you want a pooled investment vehicle, an ETF is a great way to go. Of course, there's a fun argument about taxes in ETF's vs. Actual securities.