On an annual basis, investors are reminded that ETFs are a highly tax-efficient vehicle compared to mutual fund alternatives.
But while people tend to think of the tax benefits of low-turnover S&P 500 or MSCI EAFE index-based ETFs that have limited portfolio shifts, smart beta and actively managed ETFs are similarly strong options for taxable accounts.
We published a thematic research report highlighting how common it is for mutual funds, such as the USAA Growth Fund (USAAX) or the Goldman Sachs Growth Opportunities Fund (GGOAX) to pass to shareholders tax bills of 20% (or sometimes much more) of their fund’s net asset value (NAV). Yet the tax situation is very different with ETFs.
When it comes to tax efficiency, the ETF advantage over mutual funds is primarily due to the “in-kind” receipt and delivery of securities to satisfy creations and redemptions. This is done through authorized participants (APs), which are ETF liquidity providers and have the exclusive right to change the supply of ETF shares on the market.
The ETFs do not sell securities in the market; therefore, the actions do not create a taxable gain. Even better, the fund manager can always deliver the lowest-cost basis securities to the AP to manage the tax efficiency of the fund over time, explains Chris Hempstead, head of Hempstead ETF Consulting.
Why ETF Capital Gains Occur
iShares, which offers the most ETFs, expects capital gains for approximately 5% of its lineup. Many of these are currency-hedged ETFs (not offered by some large peers), such as the $3 billion iShares Currency Hedged MSCI EAFE ETF (HEFA).
HEFA is expected to pay a capital gain approximately equal to 2% of its NAV. Currency-hedged funds are designed to neutralize long currency exposure tied to holding foreign stocks, using forward contracts that cannot be traded in-kind and often can result in a capital gain.
However, the $62 billion iShares MSCI EAFE ETF (EFA), which offers the same developed international equity exposure but without the currency hedging, will pass along zero capital gains to existing shareholders.
iShares is also not passing along capital gains for any of its single-factor or multifactor equity strategies, which are reconstituted on a semiannual basis or more frequently, based on a stated index methodology that results in relatively high turnover compared with a market-cap weighted ETF.
For example, the iShares Edge MSCI USA Momentum ETF (MTUM), which has $9 billion in assets, and which incurred a 138% turnover rate due to a shift in which stocks are currently exhibiting relatively high price momentum, has no capital gains. Many stocks inside the ETF in October were not part of the portfolio in April.
Just two of Vanguard’s 80 ETFs are expecting to have capital gains. The one with the highest percentage of NAV is the 0.9% for the $1.1 billion Vanguard Extended Duration Treasury ETF (EDV), which has risen 21% this year as rates fell sharply.
The Vanguard S&P 500 ETF (VOO), which tracks the cap-weighted S&P 500 and incurs just 4% turnover, did not incur any gain—as expected. However, we are pleasantly surprised that the actively managed Vanguard US Multifactor ETF (VFMF), which is a multicap portfolio ETF focused on value, momentum, quality and low volatility factors, is not incurring capital gains as many active mutual funds are. VFMF has a 64% turnover rate.
Lastly, SSGA has no ETFs expected to pass along capital gains to shareholders. SSGA’s lineup includes more passively managed ETFs, such as the Technology Select Sector SPDR Fund (XLK), as well as the actively managed SPDR MFS Systematic Growth Equity ETF (SYG). SYG’s recent turnover rate of 77% is relatively high.
As asset managers such as American Century, Fidelity, Legg Mason and T. Rowe Price plan to launch non-transparent, actively managed equity ETFs in 2020, investors can anticipate that these funds will likely incur limited capital gains due to the ETF structure.
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