A Closer Look at Why ETFs Are Tax Efficient

By Eric Legunn, Deutsche Asset Management

Many investors understand that exchange traded funds (ETFs) are tax efficient. This efficiency is primarily due to the fact that few ETFs distribute fund-level realized capital gains to shareholders. However, investors and advisors may find it surprising when one of their ETF holdings suddenly presents them with a distribution of realized capital gains. Let’s take a closer look at why typical ETFs are tax efficient and why, in some scenarios, ETFs may pass on fund-level realized capital gains to investors.

Realized capital gains occur when securities (which have appreciated above their cost basis) are sold for cash. However, ETFs can improve tax efficiency by using in-kind transfers to manage cost basis and to decrease the need to convert holdings to cash. In-kind transfers work by enabling an ETF to swap securities held in its portfolio for ETF shares held by an authorized participant (AP), and vice versa. This transaction is not a taxable event because the ETF does not liquidate any of its holdings. In addition, ETFs can also improve tax efficiency by using in-kind transfers to manage the cost basis of the fund’s underlying holdings (i.e. the fund can transfer low-cost-basis securities out of its portfolio). Overall, the continual use of in-kind transactions throughout a typical ETF’s day to day operations, which include portfolio rebalances (when an ETF buys and sells securities to better track its index) and redemption orders (when ETF shares are removed from circulation), improves tax efficiency.

However, ETFs sometimes do realize and distribute fund-level capital gains to shareholders. International ETFs which invest in restricted markets that do not allow in-kind transfers, and currency-hedged ETFs which use derivatives as part of their strategy are two types of ETFs that are structurally more likely to realize capital gains than other ETFs. On the other hand, ETFs that rarely distribute capital gains may do so in certain circumstances as cash sales in some funds may be unavoidable.

There are a handful of restricted international markets, including Brazil, India, and Malaysia, where local securities regulations do not permit in-kind transactions. As a result, ETFs that operate in these markets must sell securities and use the cash proceeds to meet redemption orders or to execute rebalancing trades. For redemption orders, the ETF delivers the cash it raises (instead of securities) to an authorized participant in exchange for ETF shares. These actions may cause ETFs that operate in restricted international markets to accrue fund-level realized capital gains, which are distributed to shareholders before the end of each calendar year.