Exchange traded funds have been lauded for their efficiency and tax benefits but that there are still some exceptions to the rule.
ETFs are typically seen as more tax efficient than mutual funds due to their structure. Mutual fund managers may buy or sell components to take a profit or meet redemptions from shareholders, which triggers a taxable event. On the other hand, ETFs exchange baskets of securities for ETF shares in so-called in-kind creation/redemption transactions, which do not trigger a taxable event. However, this does not mean that ETF investors should not perform their due diligence. [Why Many Enjoy Tax Benefits of the ETF Structure]
“Not all ETFs have the same tax consequences,” Todd Rosenbluth, Director of ETF Research at S&P Capital IQ, said in a research note.
For instance, Rosenbluth singled out ETFs that are tied to fixed-income assets and currency-hedged equities.
Many fixed-income indices are rebalanced on a monthly basis, and a bond ETF index would carefully managed the numerous market changes including cash flows from coupon payments, new bond issues and bonds that have been called or paid down early. Consequently, bond ETFs that try to reflect a benchmark index tend to have higher turnover rates than stock ETFs.
For instance, the Vanguard Intermediate-term Bond ETF (NYSEArca: BIV) has a 60% turnover rate, whereas the Vanguard 500 Index (NYSEArca: VOO) has a turnover rate of just 3%. Nevertheless, the turnover rate is still below the Lipper large-cap core mutual fund average of 70%.
Due to BIV’s higher turnover rates, investors may incur capital gains.
“We believe this combined with the fact that Vanguard’s ETF and mutual fund share classes have experienced strong inflows and have been less able to shed itself of less tax efficient securities, contributes to BIV’s estimated modest $0.26 capital gain for 2014 (0.3% of its net asset value),” Rosenbluth said.
According to fund company data, 24 of 324, or 7%, iShares ETFs are expected to pay a capital gain while 13% of Vanguard’s 68 ETFs will have a capital gain, with the majority from fixed-income ETFs.
Additionally, Rosenbluth pointed out that currency-hedged ETFs use currency derivatives that are rolled forward each month, which are not treated in kind. As the U.S. dollar appreciated against the euro and the yen, investors have incurred capital gains. The IRS treats currency forward contracts as 40% short-term and 60% long-term for tax purposes.
“As with many aspects of ETF analysis, there is no one size fits all approach,” Rosenbluth added. “The fund’s structure and the activities of the asset manager play a meaningful role in its tax efficiency.”
For more information on investing in ETFs, visit our ETF 101 category.
Max Chen contributed to this article.