Exchange traded funds are touted for their tax efficiency. However, some funds may come with unrealized capital gains even if investors think they are safe and haven't made any ETF sales this year.
According to a recent BlackRock study, around 55% of investors don't realize that ETFs could pay capital gains even though the security was not sold at the end of the year.
"While ETFs can be highly tax-efficient investment products, many investors are surprised to find out that it's possible to owe taxes on capital gins distributions made by ETFs even if they didn't sell the security at a gain that year," Patrick Dunne, iShares Head of Global Markets & Investments, said in a research note. "When it comes to tax efficiency, investors need to be asking the right questions or they may get a surprise in their tax bill at the end of the year."
Typically, when it comes to taxes, ETFs are more efficient than mutual funds because of the way the fund products are structured. Unlike mutual funds, ETFs usually don't sell underlying holdings for cash, which would trigger a taxable event.
Instead, the ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa.
However, this is not to say ETFs are bullet-proof to capital gains as there are situations where ETFs could be forced to make distributions. For instance, actively managed ETFs typically have higher portfolio turnovers compared to passive index funds. Other areas that ETFs have also seen distributions include fixed-income assets, leveraged/inverse, alternatives and currencies.
ETFs may have to sell positions for a number of reasons to maintain their target exposures. For example, the bond market has experienced a robust rally, and ETFs that need to reallocate positions to maintain certain exposure to credit quality or an average maturity would sell bonds that have appreciated in value.
Nevertheless, for those worried about potential capital gains distributions, each ETF provider releases a list of funds that incur capital gains annually.
Max Chen contributed to this article.