In addition to these uncommon cases where ETFs aren’t able to use in-kind transfers, there are also ETFs which generate realized capital gains directly through the strategies that they pursue. For instance, currency-hedged international ETFs buy and sell derivatives contracts to hedge fluctuations in exchange rates. The constant purchase and sale of these contracts may generate fund-level realized capital gains that get passed on to investors. In the case of a currency-hedged ETF, a realized capital gain usually indicates that hedging improved fund performance–the U.S. dollar strengthened and investors benefited from the currency hedge.
Overall, ETFs are extremely efficient when it comes to minimizing fund-level realized capital gains, largely due to their ability to transfer securities in-kind. However, investors should understand that ETFs which access restricted foreign markets or use derivatives might realize capital gains. We hope that by digging deeper into ETF mechanics, this blog gives investors a better understanding of one of the key benefits of ETF investing, namely tax efficiency due to minimal distributions of fund-level realized capital gains.
Eric Legunn is a strategist on the Thought Leadership team of Deutsche Bank’s US ETF business.
Any tax information contained within this article is merely a summary of our understanding and interpretation of some of the current tax laws and regulations and is not exhaustive. Consult your legal or tax counsel for advice and information concerning your particular situation. Neither Deutsche Asset Management nor any of its representatives may give tax or legal advice.