This article was written by Invesco PowerShares Vice President, ETF Product Management, John Feyerer.
This is the time of year when asset managers announce year-end capital gains distribution estimates for their funds. Capital gains are generated when funds sell their holdings at a profit. Due to the solid performance of the markets this year, some investors may find their tax liabilities have grown along with their portfolio balance — even if they haven’t sold their investments.
If you are concerned about capital gains taxes, there are two ways in which exchange-traded funds (ETFs) may help.
1. ETFs may defer taxable events due to their structure
Because of their unique structure, ETFs may allow investors to defer some, most or possibly all of their capital gains until they sell their investment.
Since ETFs are traded on an exchange, the majority of shareholder transactions take place on the exchange and away from the ETF, meaning that the ETF does not need to buy or sell securities in response to these shareholder transactions. Fewer portfolio transactions translates into fewer instances where capital gains may be realized by the ETF. In addition, creation and redemption transactions performed directly with the ETF are typically transacted in-kind, meaning that shares of the underlying portfolio holdings are exchanged as opposed to cash, which further limits the volume of transactions that could give rise to capital gains in the ETF.1
At Invesco PowerShares, only a small portion of our ETFs — about 4.5% of our assets under management — have distributed capital gains since each fund’s respective inception.2 These distributions represent an average of just 0.69% of NAV2 — a low figure is important because the less investors pay in taxes, the more they get to keep.
2. ETFs may help with ‘tax-loss harvesting’
Additionally, there is a technique called “tax-loss harvesting,” in which investors sell a stock at a loss (thereby offsetting any capital gains from elsewhere in the portfolio) and buy an ETF that correlates strongly to that security (thereby retaining that exposure in the portfolio)3 . Invesco PowerShares offers a variety of tools to help advisors and investors identify ETFs that correlate with individual stocks, and this flyer gives more details about the technique.
Capital gains taxes are deferred for investors who hold their funds in Individual Retirement Accounts, 401(k)s or other tax-deferred accounts. But, if you hold investments in taxable accounts, and you’re interested in potentially reducing your tax liabilities related to capital gains, now is the time to talk to your financial advisor about ETFs.