According to tax code, gold, silver and precious metals receive special treatment – the IRS views them as “collectibles” rather than capital assets. They don’t qualify for the maximum 15% tax rate on long-term capital gains. (Will the gold rally last?)

Bob Carlson for Barron’s reports that gains on the sale of gold and silver investments, including gold- and silver-backed ETFs, and gold bullion and coins (except certain U.S.-issued coins), are taxed at a maximum rate of 28% when such investments have been held for more than a year. When they are held for less than one year, gains are taxed as regular income.(Other metals to play besides gold and silver.)

Here are some other facts about precious metals ETFs that Carlson notes:

• Precious metals ETFs are organized as grantor trusts. Investors in an ETF are treated as owning undivided interests in the metal owned by the fund. When an investor sells shares in the ETF, the tax code treats that investor as having sold a share of the metal backing the fund. Thus, the investor is subject to the maximum tax on collectibles.
• If the ETF sells some of its gold or silver, as funds typically do to pay expenses, including management fees, then gains or losses on such sales flow through to the fund’s investors, though they receive no cash distribution.
• Investors aren’t allowed to own collectibles in Individual Retirement Arrangements, or IRAs, and other self-directed retirement accounts, including 401(k) plans. When gold and silver are purchased for such accounts, an amount equal to the cost of acquiring the collectible is treated as a distribution to the owner. Rather, it is included in gross income and taxed at ordinary rates, although an additional 10% penalty might apply if the owner is under age 59½.
• Evidently, these rules do not apply when gold or silver is bought for a retirement account through an ETF. Retirement accounts are treated as having purchased fund shares, not the collectibles held by a fund. It is not treated as a distribution to the owner.

Note that we’re not tax professionals, and you should call your tax consultant for specific advice.

For more stories about precious metals, visit our precious metals category. To get prepared for April 15, visit our tax category.

ProShares

A few factors affect the number of capital gains distributions to be paid out at years’ end by ETF shareholders. Factors include the path of the underlying index during the period, the size and timing of asset flows.

The impact is usually minimal in comparison to mutual fund shareholders’ responsibilities. Estimates are different from year to year and information about any fourth-quarter income distributions will be distributed separately. (Do these types of ETFs belong in your portfolio?)

For specific tax guidance, consult your tax professional.

For more stories about long-short ETFs, visit our long-short category.

ETFs have the ability to  trade intraday, so the price at which they’re bought and sold can deviate from their net asset value (NAV). Esko Mickels for Morningstar says that ETFs have a secondary source of liquidity: designated brokers (also known as “authorized participants”) who are allowed to exchange the underlying basket for units with the fund company. This mechanism limits the impact of large orders, but it also puts the liquidity of the fund in the hands of its underlying investments.

Here are 10 tips for trading ETFs that could help you get the most out of them:

1. Timing the trade: Be careful buying and selling ETF during the first and last 30 minutes of the day. An ETF’s volatility is highest at those times and wide spreads are more common.
2. Exercise caution on volatile days: Volatile days in the market can throw an ETF’s underlying value off of its bid-ask spread, so tread with caution.
3. Limit orders: Use these to define the price you’re willing to pay, thereby limiting your market impact. Read more on limit orders here.
4. Select ETFs with high trading volume: While high volume doesn’t necessarily equal liquidity, it implies that a limit order for a few hundred shares near the current mid-market price should be filled quickly. These also remain closer to their NAV.
5. Trade during an open underlying market: If you are investing in overseas markets, it is best to trade the correlating ETF when the overseas market is open. This avoids any uncertainty.
6. Use a stop-loss: A stop-loss is an automatic sell order that is triggered when an ETF’s price falls to a predetermined threshold. The most common stop-loss is set at a specific price, which allows you to limit losses. A trailing stop-loss ratchets up the stop-loss price as your ETF’s price increases. Read more on stop losses here.
7. Watch the fees: Consider broker fees for every transaction. The more trades you do, the more you are paying in fees, taking away from your gains.
8. Leveraged ETFs: Pay attention to thee funds daily, as they can move in radical directions. These also require re-balancing often, meaning more fees to rack up. More on leveraged and inverse ETFs can be found here.
9. Market makers: Market makers working for the designated brokers add liquidity and help keep the bid-ask near the ETF’s underlying value, so having more is generally desirable.
10. Distribution date: Most ETFs are very tax efficient because their turnover is low. There’s the potential that investors holding some ETFs on the day of record can trigger a capital gains event. More information on taxes and ETFs can be found here.

For more stories about ETF information, visit our ETF 101 category.

ETFs are desirable products. They’re low-cost, diversified, they trade all day on an exchange like a stock.

One thing that makes ETFs more desirable than their mutual fund counterparts is their inherent tax efficiency.  In general, ETFs are less likely to shoot off capital gains because they passively buy and hold baskets of stocks in an index, usually resulting in lower turnover and lower realization of capital gains.

This is a function of the in-kind redemption process. Unlike mutual funds, ETFs don’t have to sell securities to redeem shares. Redemptions are made by the authorized participant and are met by transferring stocks. Bear in mind, too, that most ETF capital gains distributions are very, very small and the majority of ETFs manage to avoid issuing them entirely.

In fact, Morningstar examined distributions by ETFs that track 27 indexes and found that ETFs in 25 of the categories had no capital gains distributions in the previous five years. The other two categories had very small distributions, reports CBS Moneywatch.

At the end of each year, fund providers list any expected distributions on their sites.

You can never escape the tax man, so it’s best to be armed with all the information you need to deal with him when the time comes. Always know the tax implications of an ETF you’re holding and consult your tax professional for more information and guidance.

For more stories on taxes, visit our tax category.

Kevin Grewal contributed to this article.

When you are constructing your portfolio, it is a good idea to research both products. They both have good diversification aspects and offer benefits that are exclusive to their genre.

S. Wade Hansen for Learning Markets points out the differences between ETFs and ETNs that may help you in the decision-making process. Neither type of investment is inherently good or bad – they both offer benefits. It all depends on what your goals are and what your comfort level happens to be:

• ETFs have the liquidity that comes with a single stock. ETNs are a debt obligation, so credit risk is a concern investors need to be mindful of.
• ETFs offer instant diversification because when you purchase one, you invest in a fund that buys and holds multiple assets. This includes, equities, bonds, and commodities. ETNs are not investments in funds; instead, you are buying debt from the issuer and they are backed by the full faith and credit of the issuer.
  
• ETNs have maturity dates. When you hold an ETN until the maturity date, you receive a one-time payment based on the performance of the underlying asset, index or strategy. If you wish to sell sooner, you can sell on the open market.
• When you buy an ETF, you buy ownership of a basket and its contents, not piecemeal ownership of the individual contents. The savings come from trading costs and initial capital that you would need to invest in single stocks.
• The tax treatment of ETFs and ETNs is different. With ETNs, you are taxed only upon sale. Short-term capital gains rates apply if held for less than one year; long-term capital gains rates apply if held for more than one year. As for ETFs, they could be a little trickier, especially when it comes to commodity ETFs that hold futures and leveraged funds. Doing homework on this is necessary.
  
• Both ETFs and ETNs give access to hard-to-reach markets, such as currencies and certain foreign markets. One example of the benefits of ETNs is the iPath MSCI India ETN (INP), which gave investors the ability to gain exposure to a rapidly growing economy before the India ETFs came along.
  
• ETNs have no tracking error; this can be very attractive to some investors. However, tracking error has not been a terribly big problem with ETFs.

When it comes to ETFs vs. ETNs, it comes down to tax treatment and credit risk. Step back, assess your priorities and what level of risk you’re comfortable with. This will help you make a decision that’s right for you.

For more stories on ETNs, visit our ETN category.

1. The first way to minimize one’s tax liability is understanding the very complicated Internal Revenue Code.  When it comes to investments, it is imperative to understand the internal trading cost of fund holdings by portfolio managers and the trading costs of mutual fund shares by the investor, states Ron DeLegge of ETF Guide.

Additionally, investors must keep in mind investment holding periods.  Regarding capital gains on investments, the IRS taxes them based on how long the investment has been held.  Short term-capital gains, those that have been held under one year, are taxed at ordinary income rates, where as long-term capital gains, those held longer than one year, are taxed at a much more favorable rate of 15%.

2. The second way to lower your tax bill is to coordinate your investments.  This can be done through proper asset location by holding the right asset classes in the right places, whether it be in a tax-deferred account, such as a 401(k), or a taxable account.

3. Lastly, proper utilization of ETFs will distribute little or no capital gains and improve tax efficiency of a portfolio.  A study conducted by Morningstar indicated that over the past five years , only two ETFs out of 27 distributed capital gains while just one did so over the past 10 years.

When choosing which ETFs to use, remember to do your homework because not all of them are treated equally.

Kevin Grewal contributed to this article.

Advisors know that maximizing returns in passive investment portfolios is through the management of capital distributions, writes Scott Burns for Morningstar. ETFs are one tool that usually come with low capital gains distributions and provide tax efficiency.

In a recent study comparing ETFs to open-ended index funds, the main competitor of ETFs, capital gains distributions for equity-based ETFs in 27 broad-based indexes were systematically arranged in 5-,10- and 15-year periods and then compared to open-end index funds that tracked the same benchmarks. What did the study find?

• Of the 27 ETFs, only two ETFs made capital gains distributions in the last give years and only one ETF did so in the last 10 years
• Of the 27 open-end groups, 25 made taxable distributions within the first five years and some small-caps had distributions larger than 5% of the fund’s net asset value

These results aren’t especially surprising, since ETFs were created with an innate arbitrage attribute that makes the funds tax efficient.

Taking a broader view of the entire ETF and ETN market, though, there are still some tax situations investors need to be aware of.  Of the roughly 850 ETFs and ETNs currently available, there are different tax implications in using ETF products that deal with derivatives, mostly leveraged, inverse and commodity-type ETFs. ETFs are “looked through” to their holdings and an investor would be taxed appropriately. Read our article on how these ETFs are taxed.

Our friends at Morningstar have also recently spruced up their ETF section. They’ve added new features, so be sure to check them out.

Max Chen contributed to this article.

The new provider is aiming to launch a fund of funds. Murray Coleman for Index Universe reports that the only holding would be the S&P 500 SPDR (SPY) and every month, the ETF’s adviser would sell a certain percentage of the portfolio’s shares in order to generate dividends.

The “return of capital” is return from an investment that is not considered income; it’s when some or all of the money that an investor has in an investment is paid back, to him or her.

The catch to this ETF is that by making predefined distributions on a regular basis, such payouts could be treated as return of capital for tax purposes. This could be a way to earn tax-deferred treatment of distributions from the ETF.

The S&P’s dividend yield is about 2%, and the new ETF’s return of capital will be around 6%, meaning a total distribution of about 8%, with a majority of the payments coming on a tax-deferred basis. This is only yield, though; the fund would remain invested in SPY at all times. According to the filing, at least 80% of its total assets will be invested in SPY.

This fund could potentially lead to a new wave of ETFs sporting largely tax-deferred yields.

Those who advocate the use of ETFs note that they offer low expense ratios, diversification, tax efficiency, exposure to sectors and markets that traditionally can’t be accessed through an index and transparency.  One of the greatest things they offer investors is a vast array of choices that can satisfy any appetite.

But just as with any investment, they’re not perfect and come with issues of their own. Not all of the criticism is on target, though.

David Randall of Forbes states that U.S. Oil Fund (USO) is an example of an ETF with big pitfalls.  He states that this particular ETF is a disaster because it buys futures in a bid to track a thin underlying market and deceives investors.

We believe that it is a great way to grab exposure to the volatile commodity market, especially with an expense ratio of 0.45%, and utilize it as a hedge against rising oil prices.  Additionally, we believe that all investors should do their homework, look under the hood, and have a strategy before entering or exiting a trade.  After all, you control the destiny of your money, and you don’t have to buy a fund that doesn’t meet your objectives. Not all funds are right for all investors.

We also have a strategy when it comes to investing, utilizing moving averages, exit strategies and strategies indicating when to move back into markets.  Strategies can help minimize your risk by giving you a signal to buy, as well as a signal to sell.

Another pitfall that is cited is the tax-efficiency of certain ETFs.  Some ETFs are taxed and treated as shares of a limited partnership where one is taxed on a fund’s internal trading activities.  Th IRS taxes these funds on the basis that 60% of the activity is long-term and 40% is short-term.  As for some commodity ETFs, they are structured as grantor trusts; when shares are sold they are taxed at ordinary income tax rates. The last tax pitfall can be see in leveraged ETFs, which are taxed at short-term capital gains rates regardless of how long they are held.  Keep in mind that these pitfalls arise only in a few types of ETFs, as for all the others, they still remain efficient and don’t shoot off the capital gains that their mutual fund counterparts do.

The last pitfall that opponents cite is the riskiness and exposure offered by leveraged ETFs. These ETFs are structured in such a way to give double or even triple the exposure to certain markets in either the same direction or the opposite direction.  Before investing in leveraged funds, you should be sure to be fully educated on how they work and their applications.  These funds can be beneficial for the right kind of investor.

When it comes to investing, education is your best defense for avoiding the pitfalls of ETFs. We certainly agree that if the necessary research isn’t done beforehand, you can get burned.

Kevin Grewal contributed to this article.

This decade might be lost in dollar terms, but in educational terms, it’s plenty rich. Christopher Davis for Morningstar points out some lessons:

• Lesson One. The long haul of recovery may be longer than everyone is anticipating. Stocks may have earned around 7%-10% a year, but that’s usually when measured over 20- or 30-year increments. Short-term or immediate results are not going to just appear. Investing requires patience and discipline.
• Lesson Two. Diversification is now more important than ever. For example, while most types of equities, commodities, and some bonds were way down during the recent bear market, government bonds came on strong. The case for diversification benefits just got more solid.
• Lesson Three. Dollar-cost-averaging is the practice of making regular investments which helps over-invest in overly hot markets. If you were disciplined and kept investing throughout the 2000 to 2002 bear market, you bought in at cheaper prices and likely have enjoyed a much better return on those investments.
• Lesson Four. The bottom line is that U.S. consumers must change their ways. Save, save, save and but less, even when it comes to the markets.
• Lesson Five. Minimize taxes and expenses. ETFs can help this become a realistic part of your strategy. Although taxes are unavoidable, they can be minimized by investing wisely.
• Lesson Six. The past isn’t always prologue. Just because it happened before doesn’t mean it will happen again. The market often has gone on to periods of outsize gains after long, slow periods. Stick to watching the trends and proceed accordingly.