Analyst Spotlight Archive

Analyst Spotlight: Jeff DeMaso

[For an overview of ETFs and a discussion of their advantages and disadvantages, I would direct readers to a November 2005 Research Perspective by Rusty Vanneman.]

So what topic related to ETFs did I choose to spotlight? Emerging Markets? International Real Estate? Commodities? Or maybe niche sector funds? Nope; taxes. While the tax-efficiency of ETFs is one of their selling points, there is an aspect of ETF taxation that I suspect many investors are forgetting about (or more likely, never realized in the first place).

Why are ETFs tax efficient?
Due to their stock-like structure, one of the advantages that ETFs have over the typical open-ended mutual fund is that they are, on average, more tax efficient.

When you redeem your shares of a mutual fund, the manager (assuming he or she does not have sufficient cash on hand) must sell securities in the market to generate the cash to meet your redemption. If the stocks the manager sold have appreciated in value, a capital gain is recorded. This gain must be distributed to the fund’s other shareholders, who are then taxed on it.1

But when you want to sell shares of an ETF you simply go to the market and trade it as you would any stock. You are simply selling your shares to someone else. Selling shares of an ETF may create a taxable event for that individual, but there are no capital gains to distribute to remaining shareholders of the ETF. (For more details see the box “The Role of Authorized Participants”.) This gives individual investors in an ETF more control over their tax destinies.

1(This is a simplified example as in practice there are multiple investors moving in and out of a fund on any given day. This will result in net sales or net redemptions for the fund. Additionally, a fund may have tax losses that can be used to off-set gains but the above description is the basic process by which a fund incurs a taxable event.)

Sign me up?
No capital gains distribution? Sounds great, right? Before you pick up the phone and demand to move all your money to ETFs, I ask you to stick with me a little longer. Aside from the tax implications that that action would have or the question of active versus passive management (which is a topic deserving its own article), the tax situation with ETFs is not always so cut and dry.

For starters, there is no guarantee that there will never be capital gains distributions. A reconstitution and rebalancing of an index could result in stocks being sold. Also a corporate action (such as an acquisition) or private equity could require the ETF to sell securities. These sales could create capital gains for the shareholders of the ETF.

Some ETFs Come With Unpleasant Tax Surprises
The above discussion refers only to capital gains distributions from an ETF. While the typical ETF rarely distributes capital gains, ETFs are not without distributions all together. Most ETFs regularly distribute income.

But more important, when it comes to individual capital gains realized from the sale of an ETF, the tax treatment on some ETFs, particularly those in the alternative asset space, may catch investors by surprise. For example:

• Bullion-based Commodity ETFs are considered “collectibles” by the IRS as they hold the physical underlying commodity. As a result long-term capital gains are not taxed at the 15% rate like stocks, but rather at 28%.

• The gains from Currency ETFs are taxed as ordinary income (up to 35%) regardless of how long you have held it.

• Leveraged ETFs may use short-term swaps to generate the leverage. These short-term swaps can create significant short-term capital gains which are taxed at ordinary income rates.

• Futures-Based Commodity ETFs, as the name suggests, use futures to capture the return of commodities. As futures investments are “marked-to-market” at year end. There is no deferral of gains. As an example, say you bought PowerShares DB Commodity Index Fund (DBC) for $25/share and it closes at $40/share on December 31, you would owe taxes on the $15/share gain — even if you did not sell the ETF! On top of that, the gain is taxed at 60% long-term and 40% short-term rates regardless of your actual holding period.

What about those Exchange-Traded Notes?
An Exchange-Traded Note (ETN) can be described as debt that trades like a stock and provides the return of an index. ETNs are 30 year senior, unsubordinated debt issued by Barclays Bank PLC under the iPath moniker. Barclays promises to pay the investor the return of the index minus fees at maturity. Like its ETF siblings, ETNs trade throughout the day on an exchange just like a stock. But, as with any debt, the ETNs carry the risk that Barclays defaults and fails to make good on its promise.

Aside from providing access to previously illiquid or difficult to invest in areas of the market (such as commodities, currencies, India, etc), the key selling point of the ETNs is taxes. First, the ETNs do not pay monthly dividends as the interest is built into the price of the ETN. More importantly, Barclays contends that the notes should be treated as “pre-paid contracts.” If this is the case, then investors would not pay taxes on gains until they sell the security or it reaches maturity. I say “contends” and “if” because, as Barclays does point out, the Internal Revenue Service has not ruled on how this type of product should be taxed. If the ETNs are taxed as Barclays hopes, they may have created a better mousetrap (for those willing to accept the credit risk) that avoids tracking error (minus fees), provides access to different parts of the market, and is tax efficient.

(For those interested in investing in the iPath currency products, there are additional papers that must be filed in order to receive the favorable tax position. I would direct potential investors to the iPath website for more information.)

Conclusion
Due to their ability to trade like stocks, and general lack of capital gains distributions, ETFs are typically more tax efficient than the average mutual fund. But I suspect that many investors may not be fully aware of all the potential tax consequences of their investments and may be surprised come tax time. Additionally, as our Director of Research, Rusty Vanneman, pointed out in his earlier piece in ETFs, “Ultimately, tax efficiency is about many things, such as the frequency of trading, awareness of holding periods, utilizing tax harvesting and swap strategies, and avoiding distributions, among others. An investor actively trading ETFs with no consideration of taxes will surely generate plenty of taxable events and not necessarily positive ones either.”

This spotlight article is for informational purposes only and is not an offer to buy or the solicitation of an offer to sell any securities.

-- Jeff DeMaso