Q: Let’s look at ETFs specifically. We’ve discussed on The Blog before about how they are generally designed to be tax efficient. When an investor is thinking about using an ETF, what do they need to know about capital gains?
A: Generally an investor shouldn’t let taxes, or any other cost, “wag the investment dog”. Getting the asset exposure right generally has more to do with driving your long-term investment experience than any other factor. That said, it’s important to understand that ETFs tend to be fairly tax efficient because of the way they’re structured. Because they’re index funds, they have limited turnover and thus tend to have fewer transactions that could generate capital gains than mutual funds. Plus, the majority of money coming out of ETFs does so in the form of a transfer of securities, which is more tax efficient then if the fund had to sell securities. When capital gains distributions are paid, they are given to all fund holders, regardless of when those holders purchased the fund.
Of course ETFs can at times make capital gains distributions; they just tend to make distributions less frequently (and generally smaller) than mutual funds. In 2013, 6% of the iShares fixed income ETFs paid a capital gains distribution, versus 44% for mutual funds1. It’s impossible to predict exactly how efficient ETFs will be in 2014, but, the ETF is likely to offer fewer tax surprises.
1 Source: Morningstar, as of 12/31/2013. Includes the oldest share class of all Taxable and Tax Preferred (excludes Money Market and Convertible) Open End Fixed Income Mutual Funds and iShares ETFs available in the U.S. that incepted on or before 10/31/2013. Past distributions are not indicative of future distributions.
*Rob Nestor is the head of iShares Retail Product Strategy at BlackRock and has extensive experience in ETF product development and portfolio construction.
Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.