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

December 21, 2017

Portfolio Trading Triggers

Rebalances aren’t the only drivers of security sales in ETF portfolios. Forced selling, active management and expiring derivative contracts can push capital gains to ETF shareholders.

In fixed income, portfolio turnover can come under normal conditions in even the most vanilla portfolios, when bonds cross a maturity threshold, undergo a credit downgrade, or when convertible bonds get redeemed as equity, forcing portfolio managers to sell. Vanguard’s only ETF capital gains distributions for 2017 are estimated to be in term-specific bond funds: Vanguard Extended Duration Treasury (EDV), Vanguard Intermediate-Term Bond ETF (BIV) and Vanguard Total Bond Market ETF (BND). In case you were wondering, BND is not allowed to hold bonds with less than 12 months to maturity.

The PowerShares S&P 500 BuyWrite Portfolio (PBP) writes covered calls on the S&P 500 using both at-the-money and out-of-the-money contracts. In a year like 2017, with the S&P 500 up 20.49% through November 30, out-of-the-money calls become in-the-money regularly, calling away stock positions at expiration. That’s a sale forced by the portfolio strategy and terms of the options contracts, and it triggers a capital gain. Add in the premium collected from the call-writing, and you’ve got a formula for generating a capital gains distribution. Indeed, PowerShares anticipates distributing between $1.20 and $1.45/share from PBP this year. At November 30, 2017 NAV levels, that represents 6.40% of assets.

Actively managed ETFs make capital gains distributions as well. SSGA estimates that SPDR MFS Systematic Value Equity ETF (SYV) will distribute 2% of its NAV to shareholders this year.

Futures-based commodity and currency funds have plenty of turnover too, because contracts mature monthly. Most commodity ETFs are actually organized under the 1933 act, which provides for a variety of tax treatments. Exchange-traded notes, another popular structure for commodity products, do not own portfolios and cannot realize capital gains. Grantor trusts hold physical metal, such as bars of gold or silver. Commodity pools must mark portfolios to market and issue K-1s. While many investors dislike K-1s because of the additional complexity at tax time, commodity pools offer favorable tax treatment in that 60% of the profits are treated as long-term capital gains, while only 40% are taxed as ordinary income.

There’s a new type of commodity ETF organized under the 1940 act. These “No K-1” funds offer convenience, but at a cost: All income from collateral and short-term capital gains are taxed as ordinary income. Invesco PowerShares estimated that the PowerShares Optimum Yield Diversified Commodity Strategy No K-1 Portfolio (PDBC) will pay out $0.65 to $0.75 in ordinary income this year. As of November 30, 2017, that represents up to 4.26% of NAV. Worse, all creations and redemptions occur in cash, meaning that outflows can trigger capital gains.

In recent years, currency-hedged equity funds passed large gains through to clients. According to its 2016 estimates, the Xtrackers MSCI United Kingdom Hedged Equity ETF (DBUK) distributed 18.9% of AUM as capital gains, while its competitors WisdomTree United Kingdom Hedged Equity Fund (DXPS) distributed 12.92% and iShares Currency Hedged MSCI United Kingdom ETF (HEWU) distributed 14.17%.

In many cases, portfolio turnover can mitigate capital gain realization if the portfolio manager is lucky enough to receive redemption orders on the days when trades are required. But because the timing of these trades is often highly proscribed, redemptions are sporadic and investor-driven. When the timing doesn’t work out, tax liabilities grow. In that context, it’s quite amazing that the magic of ETF tax efficiency works as well as it does, most of the time.

As the holiday season approaches, it might be time to think about giving your loved ones some tax-efficient ETFs. Look for funds with low portfolio turnover and plenty of two-way flows, avoid derivatives and forced trades, and you should be set for low-cost ownership for years to come.

At the time of writing, the author held a legacy position in IVV. Elisabeth Kashner is director of ETF research and analytics for FactSet.

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