By Todd Rosenbluth, CFRA
With the holiday giving season upon us, loyal ETF investors should remain thankful that they are unlikely to receive an early tax bill. In contrast to mutual funds, it is a rare occurrence when an ETF passes along any capital gain to shareholders if the securities remain in the portfolio let alone one that is 10% or more of the net asset value (NAV) of the fund.
Earlier in November, a thematic research article titled “Is Your Mutual Fund Prepping A Large, But Unwelcome Present?” highlighted some egregious examples of mutual funds passing along short- and long-term capital gains equal to more than 30% of the fund’s NAV. In those examples, management changes contributed to a shift in the securities inside the portfolio that spurred capital gains for shareholders. However, it is also common for a mutual fund to pass along capital gains as the fund faces redemptions and needs to raise cash. Indeed, the actions of a minority of shareholders often will impact the remaining shareholders.
But when an investor sells an ETF, his or her trade is typically crossed with another investor, just as it would with a stock that trades on an exchange. Such a transaction could result in a capital gain or loss for the seller, but all other shareholders would not be affected. Even if enough shareholders want to sell, an authorized participant might remove shares from the market by redeeming shares of the ETF to the asset manager. Yet the manager does not pay the authorized participant in cash but delivers the holdings of the ETF through what’s known as an “in kind” transaction.
Furthermore, the asset manager looks to deliver shares with the lowest tax basis, leaving a portfolio of shares purchased at or above the market price, further reducing the ETF’s potential tax burden.
In November, the three largest ETF providers — iShares, Vanguard and SSGA – announced their estimates for capital gains and once again the vast majority had nothing to disclose.
For example, more than 96% of iShares ETFs are expected to not pay a capital gain, including iShares S&P 500 (IVV) and iShares Core MSCI EAFE (IEFA). Interestingly despite monthly rebalances to reflect new issuances, just 1 of more than 90 iShares bond ETFs is expected to incur a capital gain this year. iShares Convertible Bond ETF (ICVT 54 NR), a nearly $300 million fund, is likely to incur a combined short- and long-term gain of approximately 1% its NAV.
Meanwhile, 7 of the 14 iShares ETFs that expect to pay a low-single-digit-percentage of NAV capital gain are currency hedged international equity ETFs. One example is iShares Currency Hedged MSCI EAFE (HEFA). Futures contracts used to hedge against euro and yen have to be marked to market at year end with any gains taxed.
Vanguard, which does not offer any currency-hedged equity ETFs, reported there will be capital gains for some of its mutual funds, but none of its ETFs. As such, investors in Vanguard Total Stock Market Index Fund ETF (VTI), Vanguard Total Bond Market Index Fund ETF (BND) and more than 80 other ETFs will not incur any unexpected taxes if they held on to the strategies.
State Street Global Advisors, the third largest ETF provider, expects just seven of its more than 140 ETFs to pass along capital gains taxes to shareholders. Actively managed SPDR MFS Systematic Value ETF (SYV) is one of them, but other index-based US equity products such as SPDR Portfolio S&P 500 Value ETF (SPYV) highlights the tax efficiency of most ETFs.
iShares, Vanguard and SSGA manage $2.9 trillion in ETF assets and are increasingly gathering more as investors adopt the diversified, primarily low-cost strategies to support core and tactical allocation. With less than 4% of these products passing along capital gains to shareholders who held on throughout the volatile year, the tax efficiency benefits are shining through.
Todd Rosenbluth is Director of ETF & Mutual Fund Research at CFRA.