iShares Frontier ETF’s Monster Cap Gains

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 ETF.com 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.

Cash Creation/Redemption

Another key factor that allows capital gains to be “washed” out of ETFs is the “in-kind” redemption mechanism. During redemptions for “in-kind” ETFs, the issuer can get rid of certain securities by putting them in the redemption basket for the authorized participant (AP) to sell.

In FM’s case, the bigger issue likely stems from its largely “cash” create/redeem mechanism. According to iShares, the majority of FM’s creation/redemptions are done in cash, as opposed to in-kind—UAE and Qatari securities are all “non-in-kindable”—meaning the fund itself has to buy or sell securities in the basket at the fund level, instead of at the AP level.

In short, the secret sauce of “in-kind” creations and redemptions is a bit compromised with FM, which likely added to the inability of the fund to wash out these massive gains in an efficient manner.

FM Post-Reconstitution

I want to reiterate that FM remains a groundbreaking ETF that finally provided the first pure access to investable frontier markets, as defined by MSCI.

Even though I think it’s only a matter of time before FM encounters a challenger in the space, I expect FM to remain the dominant frontier market ETF, in terms of assets, for the foreseeable future.

FM’s expected capital gains distribution is certainly not ideal, especially for newer investors who bought shares only recently. Perhaps this is simply a price to pay for access to an exciting, but less liquid and fast-changing niche like frontier markets.

But let’s not overlook that since its launch in September 2012, FM has massively outperformed broad emerging markets, delivering total returns of 45 percent.

I think most investors would take paying taxes on big gains any day over realizing losses in an underperforming ETF.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.