With the end of the year closing in on us, investors are beginning to consider the tax consequences of their portfolios and exchange traded fund investments.
Due to the ETF’s structure, the investment vehicle is generally more tax-efficient than traditional open-end mutual funds. Since most ETFs are passive in nature and track an underlying index, the funds typically have lower turnovers than active mutual funds, which means that there is a lower chance of ETFs seeing a taxable capital gains.
Moreover, due to the innate so-called in-kind transaction found in ETFs that allow the funds to transfer portfolio securities instead of raising cash to meet redemptions, ETFs won’t realize capital gains.
However, there are exceptions to the rule, and investors should monitor their ETF investments.
As of early December 2016, 11 major ETF sponsors with a combined 1,120 U.S.-listed ETFs have revealed year-end capital gains estimates and project 86 or 7.7% of the total will distribute capital gains this year, with 22 of the 86 expected to issue capital gains distributions of over 2% of their net asset value.
Adam McCullough, an analyst on Morningstar‘s manager research team who covers passive strategies, warned that ETFs have capital gains distributions usually fall under one of three categories: They invest in markets that don’t allow in-kind redemptions. They are currency-hedged. Lastly, they invest in fixed-income securities.