ETFs, Indexers Dodge The Tax Bite in 2005

January 05, 2006

Few funds post capital gains distributions in 2005, despite rising markets; still, indexing triumphs over active.

Benjamin Franklin said that "nothing in this world is certain except death and taxes."  Well, he obviously never heard of exchange-traded funds (ETFs).

The ETF industry largely dodged the tax man in 2005, with all but a few funds reporting zero capital gains for the year.  Barclays Global Investors (BGI), PowerShares, Rydex and the Nasdaq all reported zero cap gains, while the Real Estate Investment Trust VIPER (VGA) was the lone dark spot on Vanguard's otherwise clean ETF slate.  State Street Global Advisors (SSgA) didn't get away quite so easily, swooning under distributions for the SPDR O-Strip (OOO),  streetTracks DJ Wilshire Small Cap Value (DSV) and streetTracks DJ Wilshire REIT fund (RWR).  (The persistence of capital gains distributions for the small cap value category is perplexing; it is the only domestic ETF category where funds regularly report capital gains.)

The performance of the industry is remarkable considering the regular rebalancing of the indexes these funds track. Even the changeover from the S&P/Barra style indexes to the S&P/Citigroup style indexes didn't impact the tax efficiency of the related ETFs.  Perhaps most remarkable was the performance of the "active index" funds from PowerShares, which posted zero capital gains despite turnover that, for some funds, apporached 70 percent.

The positive tax performance extended beyond just ETFs to encompass the broader index family.  From the massive Vanguard 500 Index fund to the nouveau funds from Fidelity and E*Trade, most funds outside the REIT and small cap sectors managed to avoid capital gains distributions entirely in 2005.  One exception was Fidelity's Spartan U.S. Equity Index fund, a quasi-index fund that is 80 percent exposed to the S&P 500 and 20 percent actively managed; that fund posted a small taxable long-term gain, in contrast to its purely passive partner, the Fidelity Spartan S&P 500 fund.

The superior performance of purely passive funds extends throughout the industry and across different fund providers.  Consider Vanguard: Although a bastion of passive management, it also offers a significant slate of active funds.  But judging from the tax performance, investors may be better off sticking with the passive approach.

 

Consider the Vanguard Explorers Fund, an actively managed small cap growth fund, which delivered to its investors a year-end surprise of both short- ($1.57/share) AND long-term ($4.63/share) capital gains distributions.  In contrast, its passive peer - the Vanguard Small-Cap Growth Index Fund - came away with a clean slate.  For the record, the two funds offered virtually identical returns; over the past five years, the index fund has done much better, posting returns of nearly 60% against just 40% for the Explorers portfolio.

That tax efficiency could become increasingly useful in the years to come. In a recent analysis of the tax efficiency of ETF, Lipper noted that most mutual funds have benefited recently from the capital loss carryovers from the recent bear market:

"As a result of the 2000-2002 market and related large losses on many equity funds' books, distributions passed through by funds to taxable fund investors over the last four years have dropped considerably. During the last few years tax drag on equity fund performance declined from being, on average, about two times the expense ratio to being about 60% of the expense ratio in many cases, but we do not expect this trend to continue. In fact, the trend changed directions in 2004. Mutual fund short-term capital gains distributions increased 127% from an estimated $5.2 billion in 2003 to $11.8 billion in 2004, and long-term capital gains distributions increased 404% from $9.960 billion in 2003 to $50.223 billion in 2004."

 

With the loss overhang disappearing, investors have yet another reason to look towards index funds and ETFs.

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