ETFs Offer Magic For The Holidays: Freedom From Pass-Through Capital Gains Taxes

December 21, 2017

Exceptions: When The Magic Fails

Some ETFs do distribute capital gains. Low-redemption activity and high portfolio turnover make ETF capital gains distributions likely. Timing matters, because portfolio managers need redemptions to coincide with their rebalance dates if they are to replicate their indexes and maintain tax efficiency.

The SPDR Russell 1000 Yield Focus (ONEY) rebalances once per year. This year’s rebalance happened on June 26. It was a big one too, with turnover of 22.5% of the portfolio value. The portfolio manager sold 68 positions and put on 75 new ones. 

June 26 would have been a great day for an in-kind redemption, as the portfolio manager could have put the lowest-basis of the 68 positions to the AP (market maker). But ONEY has been in a redemption drought all year, so all positions needed to be traded, and gains realized.

 

Freedom From Pass

For a larger view, please click on the image above.

 

According to SSGA, ONEY will distribute 7.23% of its NAV to shareholders this December, 60.76% of these are estimated to be short-term gains, taxable as ordinary income. At a 39.6% marginal tax rate, the short-term portion alone will cost shareholders 1.74% in 2017.

The iShares Edge MSCI Min Vol USA ETF (USMV) offers a counter-example. USMV’s underlying index rebalances twice a year, at the end of May and November. USMV’s portfolio must follow suit, if it is to continue tracking its index properly. On December 1, USMV changed about 6% of its portfolio by weight, positions worth approximately $950 million. That same day, USMV had an outflow of $794 million. Interestingly, $808 million had flowed in only a few days previously, on November 29. 

 

Freedom From Pass

For a larger view, please click on the image above.

 

 

It is entirely possible that USMV’s portfolio manager was able to wash out capital gains—and avoid selling any positions—by filling the redemption basket with appreciated securities that needed their weights reduced. That’s the magic of ETFs at work, thanks to an $800 million round trip of inflows and outflows. Rebalance done, capital gains removed. 

Rebalances are common for index-tracking funds. It’s not just the complex strategic-beta equity funds like ONEY. Any fund that has specific portfolio limitations is subject to a rebalance, as are actively managed portfolios.

 

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