ETF.com's 2017 Capital Gains Report

Which ETFs are making year-end distributions, and why?

[Editor's Note: A previous version of this article stated that BND only held bonds with maturities less than 12 months. According to the prospectus, BND's index only holds bonds with maturities greater than 12 months. We regret the error.]

'Tis the season for capital gains. Once again, ETF companies are making their year-end distributions, leaving investors with a little extra cash in pocket—and a higher tax bill.

Generally speaking, ETFs are far less prone to capital gains distributions than mutual funds. But gone are the days when investors could count on one hand how many ETFs would make year-end payouts.

As complexity in the ETF landscape rises, so too has the number of ETFs making taxable distributions to their shareholders.

This year, more than 20 issuers are making year-end capital gains distributions to shareholders, impacting at least 146 ETFs, or 7% of the total ETF marketplace.

Surveying The Landscape

Rarely are investors able to see at a glance which issuers are distributing capital gains on what ETFs, and how much. Each issuer pays on its own schedule and the distribution details are often buried in press releases or on company websites. Further complicating the matter is that issuers often release distribution estimates weeks or even months prior, whose amounts sometimes vary significantly from final payouts.

This year, ETF.com investigated whether all 91 ETF issuers (as listed in the most recent ETF League Table) planned to distribute capital gains to their shareholders.

First, though, a few notes of process: Some companies in our League Table—like UBS and Credit Suisse—only issue exchange-traded notes (ETNs), which hold no securities and therefore don't pay out capital gains. Other issuers, like Nationwide or Point Bridge Capital, launched their ETFs so recently that these funds likely did not have enough time to generate much in the way of capital gains. We excluded those issuers as well.

As of Dec. 19, 2017, 20 ETF issuers had not published their distribution information or replied to request for comment in time for publication. An additional 9 issuers declined to comment, or said that their distribution information would be announced at a later date.

Of the remaining issuers, 25 issuers said either through official documentation or via email and phone interviews that they did not plan to pay out capital gains distributions to their clients. These include big names, like Charles Schwab and ALPS, and many smaller, specialty issuers, like Serenity Shares and ACSI Funds.

That leaves 23 issuers with at least one ETF making a capital gains distribution to shareholders. For a full list, see the table at the end of this article.

What Makes ETFs Tax Efficient

To understand why these ETFs in particular are paying out capital gains distributions, first you need to understand why most ETFs don't.

Unlike mutual funds, which rely heavily on active management, ETFs tend to be index funds with low turnover. Less selling activity means fewer capital gains.

But that's not the entire reason.

When investors wish to exit an ETF position, all they have to do is sell their shares, like a stock. The ETF issuer itself doesn't have to sell any securities; thus, no capital gains can occur. This is much simpler than mutual funds; any time an investor wishes to exit a mutual fund, the issuer usually must sell securities to raise enough cash to satisfy that redemption request, potentially generating capital gains.

ETFs are more tax-efficient on an institutional scale, too. When authorized participants—the special ETF market makers who have the ability to make and destroy ETF shares—wish to redeem their ETF shares, they can do so by trading them in to the issuer, which delivers an equivalent amount of the ETF's underlying holdings in an "in-kind" transaction. It's a switcheroo, not a sale; thus, it too generates no capital gains.

In fact, ETF issuers can even pick and choose which shares to give to APs, meaning they can offload the shares with the lowest possible cost basis (and biggest potential to generate a profit, if sold). That leaves the ETF issuer with shares bought at or above today's market price, thus reducing the fund company's total tax burden even further.

Why ETFs Pay Out Cap Gains

However, none of this means ETFs are immune from paying out capital gains. There are many reasons funds might still make yearly distributions, including:

1. High turnover

Many active, and even many smart-beta ETFs, engage in the frequent buying and selling of securities to achieve some alpha (or smart beta).

2. Forced selling of securities

Some ETFs are forced to sell securities often to maintain their index objective. Examples include bond ETFs targeting a specific maturity, or leveraged and commodity ETFs that hold futures contracts. To stick to their mandate, these ETFs must constantly sell aging securities and buy new ones. Lots of sales mean lots of potential for capital gains. ETFs may also be forced to sell securities when an index is reconstituted or changed, or if securities fall below some capitalization or liquidity threshold.

3. Portfolio concentration

Thematic funds or those with highly concentrated portfolios often must frequently sell assets to maintain diversification requirements, as set forth in their investment objectives.

4. Low redemption activity

Low redemption activity can also generate capital gains if it comes at inopportune times. If not enough APs redeem their shares before a big annual or quarterly rebalance, there's no way for ETF issuers to offload their lower-cost-basis securities. That can result in big capital gains incursions. This can be especially problematic for "hot" sector ETFs, whose constituent stocks see large, high-velocity increases; or for tactical ETFs that are forced to sell to achieve their particular objective.

5. Cash transactions

Although most ETF redemptions occur in-kind, not all do. Some bond ETFs, for example, use cash transactions or some or all of their redemptions.

State Street: Unfortunate King Of Capital Gains

This year, State Street issued the most capital gains payments to investors, with 34 of its 131 ETFs (26%) making distributions.

It wasn't readily apparent why so many of State Street's ETFs paid out gains, but higher portfolio turnover could be to blame: 21 of the distributing ETFs were smart-beta funds, while another four were actively managed.

Interestingly, State Street also had the ETFs with the highest capital gains by dollar amount per share: the SPDR S&P 600 Small Cap Growth ETF (SLYG), at $9.00/share; the SPDR S&P Internet ETF (XWEB), at $6.68/share; and the SPDR S&P 600 Small Cap Value ETF (SLYV), at $5.89/share. (Note: We report these by dollar amount instead of percentage net asset value because many issuers still have only posted estimates of their distributions. Exact percentages of NAV will depend on whatever the NAV is on the ex-dividend date.)

Smart Beta vs. Active ETFs

Of the 146 ETFs paying out capital gains distributions this year, 71 of them (or 49%) are smart-beta ETFs.

At first glance, that might seem a surprisingly high percentage. But smart-beta funds make up 48% of the total ETF marketplace (using an admittedly very wide net that includes traditional factors like growth and value), which means our data set is simply an accurate cross section of the greater ETF landscape.

There is little commonality among the smart-beta ETFs that post gains, though curiously, smart-beta ETFs tended to pay out much larger (by dollar size) actual or expected distributions than their active counterparts. Without more information on how this compares in percent NAV terms, however, it's difficult to draw any meaningful conclusions.

ESG, Tech ETFs Biggest Offenders

More interesting, perhaps, is the fact that 16 ETFs in our data set fall under the label "socially responsible," meaning that some 32% of all (environmental, social and governance (ESG) ETFs are paying out capital gains this year. These include some of the more (but not the most) popular ESG ETFs, such as the SPDR SSGA Gender Diversity Index ETF (SHE) and the SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX).

The likely culprit behind these gains is the strict mandates ESG ETFs must adhere to, which can force issuers to sell off securities. Furthermore, as individual companies gain or lose in ESG rankings systems, their weightings in ESG ETF baskets must be adjusted accordingly. Put another way, the more “active” a strategy, the more likely it’s going to have some unavoidable taxable turnover.

Furthermore, 10 technology ETFs, or one in six tech ETFs, paid out capital gains this year, and some had sizable amounts to distribute. Technology ETFs with large distributions include XWEB, with $6.68/share (8.9% of NAV); and the SPDR S&P Technology Hardware ETF (XTH), with $5.62/share (6.8% of NAV). Also, although the iShares Edge MSCI Multifactor Technology ETF (TCHF) is estimated to pay out $1.96 to $2.39/share, that represents some estimated 4.8-5.8% of NAV.

The relative prevalence of tech ETFs in our data set shouldn't be much of a surprise. Tech stocks saw enormous and rapid gains this year. When stocks rise far and fast, it can be difficult for issuers to offload their lower-cost-basis securities—especially when ETF volumes are low, as is the case for XWEB and XTH. Further complicating the matters for XTH and XWEB is a diversity mandate that stipulates the ETFs must have at least 22 stocks in their baskets at rebalance time.

Target Maturity Bond ETFs Make Distributions

On the fixed-income side, a majority of ETFs paying out gains were funds that held a maturity target. Thirty-one (31) bond ETFs planned to pay out capital gains distributions to shareholders, 16 of which (52%) attempted to hit some target maturity.

That includes two of three Vanguard ETFs paying out capital gains this year: the Vanguard Intermediate Term Bond ETF (BIV), the Vanguard Extended Duration Treasury ETF (EDV) and the Vanguard Total Bond Market (BND). This isn’t exactly surprising; as mentioned earlier, a bond portfolio with a target maturity must constantly adjust its holdings to stay on target, buying longer-dated bonds and selling shorter-dated ones.

Nonvanilla fixed-income ETFs also represented a sizable number of ETFs making distributions: seven smart-beta bond ETFs and six actively managed bond ETFs paid out capital gains. Notably, this included the largest PIMCO ETF, the $8 billion PIMCO Enhanced Short Maturity Active ETF (MINT).

Conclusion … And A Word Of Caution

We caution readers that these numbers are subject to change as more issuers make their capital gains distributions and publish more information about what's to come. The list of ETFs making capital gains will undoubtedly grow in the weeks to come. 

Table 1: Issuers Not Making Any Capital Gains Distributions For 2017

Sources: Individual company websites, documentation and PR. All data current as of 12/15/17.

Table 2: ETFs With Capital Gains Distributions For 2017

Sources: Individual company websites, documentation, and PR. All data current as of 12/14/17. Distribution data includes estimated and actual distribution data.

Lara Crigger can be reached at [email protected]