[Editor's Note: A previous version of this article stated that BND only held bonds with maturities less than 12 months. According to the prospectus, BND's index only holds bonds with maturities greater than 12 months. We regret the error.]
'Tis the season for capital gains. Once again, ETF companies are making their year-end distributions, leaving investors with a little extra cash in pocket—and a higher tax bill.
Generally speaking, ETFs are far less prone to capital gains distributions than mutual funds. But gone are the days when investors could count on one hand how many ETFs would make year-end payouts.
As complexity in the ETF landscape rises, so too has the number of ETFs making taxable distributions to their shareholders.
This year, more than 20 issuers are making year-end capital gains distributions to shareholders, impacting at least 146 ETFs, or 7% of the total ETF marketplace.
Surveying The Landscape
Rarely are investors able to see at a glance which issuers are distributing capital gains on what ETFs, and how much. Each issuer pays on its own schedule and the distribution details are often buried in press releases or on company websites. Further complicating the matter is that issuers often release distribution estimates weeks or even months prior, whose amounts sometimes vary significantly from final payouts.
This year, ETF.com investigated whether all 91 ETF issuers (as listed in the most recent ETF League Table) planned to distribute capital gains to their shareholders.
First, though, a few notes of process: Some companies in our League Table—like UBS and Credit Suisse—only issue exchange-traded notes (ETNs), which hold no securities and therefore don't pay out capital gains. Other issuers, like Nationwide or Point Bridge Capital, launched their ETFs so recently that these funds likely did not have enough time to generate much in the way of capital gains. We excluded those issuers as well.
As of Dec. 19, 2017, 20 ETF issuers had not published their distribution information or replied to request for comment in time for publication. An additional 9 issuers declined to comment, or said that their distribution information would be announced at a later date.
Of the remaining issuers, 25 issuers said either through official documentation or via email and phone interviews that they did not plan to pay out capital gains distributions to their clients. These include big names, like Charles Schwab and ALPS, and many smaller, specialty issuers, like Serenity Shares and ACSI Funds.
That leaves 23 issuers with at least one ETF making a capital gains distribution to shareholders. For a full list, see the table at the end of this article.
What Makes ETFs Tax Efficient
To understand why these ETFs in particular are paying out capital gains distributions, first you need to understand why most ETFs don't.
Unlike mutual funds, which rely heavily on active management, ETFs tend to be index funds with low turnover. Less selling activity means fewer capital gains.
But that's not the entire reason.
When investors wish to exit an ETF position, all they have to do is sell their shares, like a stock. The ETF issuer itself doesn't have to sell any securities; thus, no capital gains can occur. This is much simpler than mutual funds; any time an investor wishes to exit a mutual fund, the issuer usually must sell securities to raise enough cash to satisfy that redemption request, potentially generating capital gains.
ETFs are more tax-efficient on an institutional scale, too. When authorized participants—the special ETF market makers who have the ability to make and destroy ETF shares—wish to redeem their ETF shares, they can do so by trading them in to the issuer, which delivers an equivalent amount of the ETF's underlying holdings in an "in-kind" transaction. It's a switcheroo, not a sale; thus, it too generates no capital gains.
In fact, ETF issuers can even pick and choose which shares to give to APs, meaning they can offload the shares with the lowest possible cost basis (and biggest potential to generate a profit, if sold). That leaves the ETF issuer with shares bought at or above today's market price, thus reducing the fund company's total tax burden even further.