Some ETFs Deliver Cap Gains Hit

Tax efficiency is one of the hallmarks of ETFs, with the investment vehicle’s use of “in kind” transactions allowing ETFs to be far more tax-friendly than their mutual fund brethren.

ETFs create and redeem existing shares with authorized participants through this in-kind process, which is not a taxable event according to current tax law.

This process enables issuers to choose which shares they exchange with the authorized participants, allowing them to offload those with the lowest cost basis. This raises the cost basis of the current shares, reducing the fund’s tax burden.
 

Generally, this process works. Capital gains distributions this year bolster ETFs’ reputation as a tax-friendly vehicle, with most funds avoiding distributions. However, investors should be aware that this isn’t necessarily true across the board.

Some stocks are not able to be transacted in-kind. For example, some emerging markets require cash settlement, which means distributions are more likely from these types of funds.

KraneShares Holders Get Hit
KraneShares is one issuer that is paying out some hefty distributions on some of its ETFs.

Several of the issuer’s ETFs are paying distributions that are greater than 5% of the funds’ NAV. When the funds pay out the distribution, the funds’ NAV decrease by this amount on the ex-date.

KraneShares ex-date was Dec. 29. Consequently, this drop can be seen in the recent performance of the ETFs (though investors should keep in mind that market movement could simultaneously affect NAV as well).

Double Whammy For KWEB
Funds that have experienced losses for the year are not necessarily safe from capital gains distributions either. It has been a rough year for the KraneShares CSI China Internet ETF (KWEB). The ETF is down 52.4% for the year.

Adding insult to injury, the ETF distributed a long-term capital gain of $1.4645 per share, just under 4% of NAV.

KWEB has seen a shocking amount of flows this year, with nearly $8 billion piling into the fund year-to-date as of mid-December. Much of the flows entered the fund after performance started to suffer in the summer months.

Courtesy of FactSet

These strong inflows, in combination with index rebalances that resulted in trimming stocks that had seen significant price appreciation, were factors in the larger capital gain distribution this year.

Since all who hold the ETF are subject to the capital gain distribution, investors who have lost money on their investment would be further disadvantaged by this distribution even though they have not personally experienced gains.

Though it seems counterintuitive, KWEB perfectly illustrates how these distributions are not necessarily linked to fund-level performance. Given that all of KWEB’s gain is long-term, this means the gain was generated from the sale of securities within the ETF that had been held for longer than a year.

Leveraged ETFs Get Hit Too

ETFs that use derivatives can also be prone to paying out distributions, with several leveraged ETFs paying out high distributions this year.

Due to the significantly higher level of volatility in leveraged ETF returns, investors are less likely to feel the hit from these distributions. For example, holders of the ProShares Ultra Financials (UYG) ETF might feel like this 4.5% hit is minimal compared with the fund’s 78.1% gain for the year.

While holding leveraged ETFs for the long term is not recommended, anyone who purchased the Direxion Daily Cloud Computing Bull 2X Shares (CLDL) or the Direxion Daily Dow Jones Internet Bull 3X Shares (WEBL) in the second half of the year is likely not as happy about the further hit to performance.

Not An Exhaustive List

While the ETFs listed in here are not the only ones that are paying out higher distributions, it is important to remember that the vast majority of ETFs are distributing minimal to no capital gains.

The ETF remains the gold standard when it comes to tax efficiency. However, the potential for capital gains distributions in certain types of ETFs is something investors should look out for.

Contact Jessica Ferringer at [email protected] or follow her on Twitter