ETF Tax Shocker: Huge Payout For Rydex Inverse Funds

December 10, 2008

 

Unfortunately, this type of "in-kind" redemption activity is less likely with inverse and leveraged ETFs. Inverse ETFs hold options and swaps as their core assets, and rely more on cash than in-kind redemptions (you can't distribute a swap to another party, for instance). In a cash redemption process, if a market maker delivers 50,000 shares of an inverse ETF to the fund company, that fund company must sell options and swaps to raise cash and pay the market maker. It's the same system traditional mutual funds use, and it means there's no dodging the tax man.

How Did The Gains Occur?

There's no way to determine exactly when and where a fund like REC accrued gains, but you can guess by looking at a few factors, starting with the fund's performance. 

 

REC performance

 

The value of REC rose steadily after the fund's inception in June, as the Energy sector as a whole weakened. It then spiked even higher during the October market meltdown, before trending back down to Earth over the remainder of the year.

All that upward movement from June through mid-October created a nice platform for gains to occur. REC aims to deliver 200% of the daily performance of its index, so as the index dropped lower and lower, the fund was continually closing out rising swap and options contracts on a day-by-day basis to maintain its exposure, locking in gains each time.

What is curious is why the fund was unable to compensate for these gains by locking down similar losses as the fund declined in the second half of October. The fund's tax year ended Oct. 31, and as the chart shows, by that point, the fund had retreated significantly. In fact, as of Oct. 31, it stood up just 50% since its June 10 debut, trading at $112.80/share, compared with $75/share at launch. That's a nice gain, but it's nothing to justify an 86% capital gains payout.

A possible explanation comes from looking at the change in the fund's assets under management over time. REC launched on June 10 with 100,000 shares outstanding, worth $7.5 million at a price of $75/share. It stayed at 100,000 shares through Sept. 17, by which point the fund was trading for $118.33/share and held $11.8 million in assets.

But at the close of trading on Sept. 17, a market maker redeemed half the shares in the ETF: 50,000 shares in total, worth $5.9 million. Rydex would have been forced to close out approximately half of its options and swaps contracts that day to meet the cash demand. That single event could have triggered a large capital gain. After all, at that point the fund was up 56% on the year.

The gain from that kind of sale was magnified by the fact that the amount of the fund's shares outstanding dropped in half, so any gains generated both prior to and during that redemption would have been divided among half as many shares.

Rydex says that in the future, it hopes that the funds will be more tax efficient as they gain size and breadth in the marketplace.

"It was a confluence of the age and size of the fund, and once-in-a-century economic circumstances," explained Kevin Farragher, ETF business manager at Rydex. "One would hope in the future, further subscription to the fund and additional creation/redemption activity would work to at least bring the cost basis of the fund down to something akin to the present trading value, and that distributions will be smaller in the future."

What Will Happen With ProShares?

The large payouts in the inverse Rydex ETF have many wondering what will happen with ProShares, which offers the largest family of inverse ETFs on the market. ProShares has not made estimated payouts available on its family of ETFs, and declined comment on payouts in 2008.

There's reason to believe, however, that payouts will be substantially lower. The ProShares funds are significantly larger on average than the competing Rydex inverse funds, which also tend to be newer to the market. According to Morningstar, the inverse ProShares ETF with the least assets as of Oct. 31 was the ProShares UltraShort Mid Growth (SDK), with $10.6 million in assets; twice as much as REC. Most of the ProShares ETFs have $25 million or more in assets (and some much more).

With a larger asset base and (for the most part) longer trading records, the ProShares ETFs should be less impacted by unique situations like isolated redemptions activity. With longer trading records, they should also have had more time to offset gains with commensurate losses.

That said, there will likely be some payouts on the inverse ProShares ETFs. Last year, ProShares paid gains on 15 of its inverse and leveraged ETFs. The largest on a dollar basis was in the ProShares Ultra Oil and Gas ETF (NYSEArca: DIG), where the payment was equivalent to approximately 6% of the fund's NAV.

The ex-dividend date last year for ProShares was Dec. 20, so if you're worried, you still have a few days to trade around the issue.

 


Matt Hougan is editor of IndexUniverse.com. He can be reached at: [email protected]

 

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