Many investors have added exchange traded funds to their investment portfolios for a number of reasons, such as the tax benefits of the ETF structure.
ETFs, like mutual funds, hold a basket of securities and reflect the performance of their underlying holdings. However, when mutual fund managers rebalance their portfolios, they accrue capital gains that are passed to shareholders.
“Even if an investor did not sell shares in the fund during the calendar year, when the manager takes profits in a holding or trims it to meet redemptions from other shareholders, other investors share in the tax burden,” writes Todd Rosenbluth, S&P Capital IQ Director of ETF & Mutual Fund Research, in a research note.
For instance, Rosenbluth pointed out that the Royce Premier Fund (RYPRX), a $3 billion small-cap core fund, underperformed peers by 475 basis points in 2014 after incuring a $2.07 per shares long-term capital gain, despite an extremely low 9% turnover rate, well below the 68% Lipper small-cap core peer average.
In contrast, the iShares Core S&P Small-Cap ETF (NYSEArca: IJR), which tracks the S&P SmallCap 600 index, showed a 14% turnover rate while the Vanguard Small Cap ETF (NYSEArca: VB), which follows the CRSP US Small Cap Index, had a 10% turnover rate. However, neither IJR nor VB incurred a capital gain in 2014.