Exchange traded funds are touted for their tax efficiency. Nevertheless, while the majority of ETFs operate without a hitch, some ETFs can on occasion issue capital gains distributions.
“ETF sponsors anticipate capital gains distributions from just a small minority of funds,” according to Morningstar analyst Robert Goldsborough.
These few ETFs that issue capital gains distributions are seen as an outlier. The ETF structure would usually negate any taxable events when diminishing or increasing holdings. Specifically, many passive ETFs inherently have low turnovers. More importantly, ETFs have to ability to redeem securities “in-kind” where fund operators can sidestep capital gains by swapping securities for other securities without incurring large capital gains. [ETFs & Mutual Funds: Lump of Capital Gains in Your Stockings]
In contrast, traditional mutual funds typically redeem securities by selling off a position for cash, triggering a taxable event. [Worried About Year-End Capital Gains Taxes? ETFs May Help]
Of the seven large ETF providers that have published capital gains distribution estimates, including iShares, Vanguard, State Street Global Advisors, Charles Schwab, PIMCO, Guggenheim Investments and First Trust, only 74 of 712 funds will issue capital gains distributions, with many less than 1% of the ETFs’ net asset value. In contrast, some equity mutual funds have announced capital gains distributions of 5% to 10%.
For the most part, ETFs that issue capital gains distributions typically experience greater trading activity, use futures contracts, see a significant change up in its underlying index or track fixed-income securities.