iShares Frontier ETF’s Monster Cap Gains

December 02, 2014

Sometimes index funds can be vulnerable to big capital gains payouts, too.

iShares recently released its estimated capital-gains distributions for 2014. And, not surprisingly, the iShares MSCI Frontier 100 ETF (FM | D-68) expects to pay out capital gains of $0.91-1.11 per share, amounting to roughly 6.3-7.6 percent of its closing net asset value on Nov. 20.

The exact distribution amount isn’t yet known, but this confirms that FM will in fact pay out a massive distribution on Dec. 24, with an ex-dividend date of Dec. 17.

At Analytics, we brought up the possibility of this happening earlier in the year when iShares announced the $654 million FM would begin a gradual phase out of UAE and Qatari securities, starting in May and ending in November.

Just to recap, MSCI announced the promotion of UAE and Qatar from frontier markets to emerging market status in its June 2013 classification review.

When the phaseout began, 22 securities from Qatar and UAE needed to be “sold out” of the fund and replaced. Those 22 securities also represented roughly 35 percent of FM’s overall weighting at the time. Clearly, that implied huge turnover.

But isn’t the ETF structure supposed to be tax efficient and avoid these types of distributions?

Yes, to a certain degree, and dependent on a few factors, including its trading history, flows and its creation/redemption process.

What Worked Against FM?

For starters, FM is still a 2-year-old fund, and it’s been a wildly popular ETF in its short life span. FM has grown more than 3,000 percent in terms of flows since Jan. 1, 2013, when it had just $19 million in assets.

An ETF’s ability to “wash out” low-cost-basis securities is one feature that makes them so tax efficient over the long run. But there also needs to be sufficient redemptions for this to happen.

Amplifying odds of capital gains, the MSCI UAE and MSCI Qatar indexes are up 153 and 46 percent, respectively, since FM launched in September 2012, through Nov. 25, 2014.

With such strong performance during such a short life span and strong inflows, FM simply had little chance to weed out these lower-cost basis positions.

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