But these aren’t the only reasons ETFs can kick off capital gains. Some of the other triggering events can be:
- Performance. Market performance has ranged between 10% and 19% during the funds’ fiscal year (March 1, 2009-Feb. 28, 2010), which makes tax loss harvesting difficult because of gain positions combined with fewer loss opportunities.
- Corporate actions. Corporations, governments, agencies and other issuers frequently utilize embedded call options (when the user has the right to call bonds at a predetermined price level; any capital gain embedded in the position is recognized) and tender offers (the offer to tender bonds at a level higher than the current market levels) in order to get holders to sell back their holdings. If the portfolio manager accepts a tender offer, the capital gain or loss is recognized.
- The infancy of the ETF. In markets that are gaining, new ETFs have few chances to generate capital losses.
- Portfolio concentration. Because of 1940 Act rules, asset sales can be required at inopportune times. There may also be a limited number of securities in a specific sector or country, making tax loss harvesting difficult.
- Market regulations. In certain markets, there may be an inability to utilize the in-kind structure because of various regulations, reducing tax efficiency.
In most cases, the distributions are small and manageable ones. What you need to decide if, as an investor, you’re willing to take the risk of a capital gains distribution by purchasing a fund declaring them now. If it’s not worth it, consider waiting until after the ex-date (the first date following a distribution that new investors would not be taxed) to purchase.
Capital gains in ETFs are relatively rare and often very small. Of the more than 900 funds trading today, a small handful actually see distributions. Every once in awhile, though, a fund will declare a high distribution, and it’s important to decide how you’ll handle purchasing the ETF, holding the position or selling prior to the ex-date.
One thing that makes ETFs more desirable than their mutual fund counterparts is their inherent tax efficiency. In general, while active ETFs are gaining in popularity, 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 typically 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.