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.
“Aside from a handful of ETFs falling into one or more of these buckets, 2016 capital gains distributions from ETFs will be few and far between,” McCullough said.
Due to a strengthening U.S. dollar, currency-hedged ETFs will issue capital gains distributions. The funds must roll forward currency derivatives contracts on a regular basis to hedge against foreign exchange fluctuations, which triggers a capital gain as the dollar appreciates against the foreign currencies. Currency-hedged ETFs make up 14 of 22 ETFs with projected capital gains distributions of over 2% of their NAV.
The iShares MSCI Asia ex Japan Minimum Volatility ETF (NYSEArca: AXJV) is this year’s largest capital gains distributor at an estimated 25.9% of NAV, according to McCullough. AXJV tracks stocks from China, South Korea, Malaysia and Taiwan, and these countries don’t allow in-kind redemptions. Since rebalances are settled in cash, ETF providers can’t utilize the tax-efficient tool.
Fixed-income ETFs are probably one of the most prominent areas where investors will see capital gains distributions as many of these funds have billions in assets under management, reflecting their widespread usage. The only saving grace is that the estimated capital gains distributions are quite small, typically totaling less than 1% of the ETFs’ NAV. For instance, the Vanguard Total Bond Market ETF (NYSEArca: BND) has $31.3 billion in AUM and is expected to incur a capital gains distribution of 0.04% of NAV.
“From an ETF sponsor perspective, those with the most currency-hedged or fixed-income offerings have the greatest number of ETFs expected to distribute capital gains,” McCullough said.
Blackrock’s iShares and State Street Global Advisors each have an estimated 21 of their ETFs will issue capital gains, followed by Deutsche X-trackers with 10, WisdomTree with 9 and Guggenheim with 9.
For more information on ETFs, visit our ETF 101 category.