By Ryan Issakainen
Ryan Issakainen is an exchange-traded fund strategist for ETF provider First Trust.
WHEATON, Ill. (MarketWatch) — One of the biggest attractions of exchange-traded funds is that they are often considerably more tax-efficient than mutual funds. Many ETFs regularly take steps to avoid the annual capital gains distributions that can disrupt the tax planning of investors in traditional mutual funds. With year-end tax considerations coming into focus, this is a factor investors should consider.
The process by which ETF shares are created and redeemed is the key to the tax efficiency they enjoy. For most equity-based ETFs, the creation/redemption of shares is a function of large institutional investors making so-called in-kind exchanges of shares in an ETF’s underlying holdings for large blocks of ETF shares known as “creation units.”
Through this process ETFs are able to grow and contract without the necessity of buying or selling securities, a move that could result in capital gains, thus triggering taxable distributions to investors.
Yet when it comes to taxes, investors should always remember that not all ETFs are the same. The tax efficiency associated with “plain vanilla” ETFs does not carry through for all exchange-traded products.
For example, levered and inverse ETFs are often less tax-efficient because these funds generally use a high level of portfolio turnover to achieve their objectives. They increase and decrease exposure to various asset classes on a daily basis via derivatives, such as swaps and futures contracts. As a result, many levered and inverse ETFs have historically made substantial capital gains distributions.
Additionally, there are a few odd cases in which ETFs may produce less tax-efficient exposure than their underlying holdings. Such is the case for ETFs that track master-limited partnership (MLP) indexes. When an ETF allocates more than 25% of its portfolio to MLPs, it no longer qualifies as a tax-exempt, regulated investment company; instead, these funds are subject to federal corporate income tax. This tax liability is reflected in the daily calculation of a fund’s net asset value, which has often resulted in significant tracking error between MLP ETFs and the indexes that they follow. Continue reading
