The ETF Tax Magic
Most of the time, when an investor sells an ETF, the shares of the ETF trade hands without any trading of the underlying holdings; hence, no taxable events for the other investors. That’s fantastic, but it gets better, and here’s where the surprising tax magic comes in. (Keep in mind that here I am referring to nonleveraged, noninverse ETFs that invest in passive equity indexes. The tax treatment for ETFs in certain asset classes, such as commodities and MLPs, or that invest through futures or derivatives, can be more complex.)
When an issuer goes through the creation/redemption process, it exchanges shares of the ETF for baskets of the underlying holdings through major banks or trading firms called authorized participants (APs). With each redemption, the issuer systematically unloads the lowest basis holdings onto the APs.
For example, suppose IWM has a large stake in Vail Resorts (MTN), from years ago, with a cost basis of $25, and it currently trades around $129. Instead of selling its shares in MTN and taking a huge capital gain, it gives the shares with the lowest cost basis to the APs as part of its exchange for units of IWM, thus shifting the unrealized capital gains away from the fund and onto the market makers who buy and redeem ETF shares.
In general, the more creations and redemptions that occur in an ETF, the more the ETF issuer is able to ratchet up the tax basis in its underlying ETF holdings—and eliminate the tax exposure for the ETF investors.
This process has been phenomenally successful. In fact, the vast majority of nonleveraged equity ETFs has never issued capital gains distributions. ETFs are truly delivering on the promise of tax efficiency.
With the S&P 500 still up 178% from its 2009 low, mutual fund investors should be extra careful to not get stuck with exposure to unrealized gains. For investors looking to optimize after-tax returns, and for their advisors with increased mandates to be true fiduciaries, the tax magic of ETFs should only increase the attractiveness of the ETF structure.
David Lichtblau is CEO of ETF.com and can be reached at [email protected].