Why Are Certain ETFs Less Tax-Efficient?

 |  Includes: DJP, EEM, VWO
by: Morningstar

By Patricia Oey

Investors have been told that exchange-traded funds are more tax-efficient than mutual funds. While the data confirm this to be true, it does not mean ETFs are magical tax-avoidance vehicles that the IRS blessed with supernatural traits. For example, ETFs do not prevent taxes on dividend and interest income. However, when dealing with capital gains, the claim of ETF superiority has thus far rung true.

Equity-based ETFs distribute capital gains less frequently than open-end mutual funds of both the actively managed and passive varieties. In the rare cases when ETFs do make capital gain distributions, they tend to be smaller than their open-end fund counterparts in the same asset class. Most of the tax efficiency of these equity ETFs comes from the fact that they are passive funds that track market-cap-weighted indexes, which result in much lower portfolio turnover relative to actively managed mutual funds.

The second reason that has made ETF tax efficiency seem almost legendary is how the funds deal with fund outflows, or investor redemptions. When mutual funds have outflows, they have to sell holdings to generate cash and also pass on any realized capital gains to fund investors. When ETFs have outflows, they conduct an in-kind transaction, exchanging holdings for ETF shares, which are then "destroyed." ETFs can select the shares to exchange, which allow them to purge securities with embedded capital gains. Because these are in-kind transactions, and not cash transactions, capital gains are not realized.

It's not that mutual funds cannot legally conduct in-kind transactions; it is simply impractical in most cases. Because ETFs deal directly only with institutional-authorized participants, and not retail investors, they do not have to worry about generating and doling out cash.

ETFs can also opportunistically use cash transactions for securities with unrealized capital losses. These losses can be used to offset future capital gains. These cash transactions, while not as frequent as in-kind transactions, can be done as part of a redemption or during an index rebalance.

In this article, we will highlight which asset classes are not able to meet the aforementioned criteria and therefore are usually less tax-efficient. We will also discuss other issues that may drive capital gains distributions across asset classes. Investors should note that these tax issues are specific to funds held in taxable accounts--investors will be able to avoid most of these tax concerns by holding funds in tax-deferred accounts.

Bonds Mature, But Fixed-Income ETFs Don't
While most of the large, popular equity ETFs have never made capital gains distributions, fixed-income ETFs have at times made distributions, albeit very small ones. The reason for this is that fixed-income ETFs need to maintain a relatively consistent duration (a measure of interest-rate sensitivity), which drives portfolio turnover. When bond markets are stable, fund managers are able to turn over the portfolio without incurring capital gains.

However, this is not the case when fixed-income securities rally. In 2011, for example, a strong performance in Treasuries was the main reason a number of fixed-income ETFs had capital gains distributions last year. Fixed-income ETFs are also different from equity ETFs in another way: Debt securities can be retired early for cash, forcing funds to realize and distribute capital gains. In 2010, many homeowners refinanced their mortgages because of record-low interest rates. As a result, fixed-income ETFs holding mortgage-backed securities were forced to sell these securities and realize distributable capital gains.

Abstract Assets, Different Tax Rules
Another group of exchange-traded products that are less tax-efficient are funds that invest in derivatives contracts, typically futures contracts. Most of these products are commodities funds, as investing in futures contracts is a far more practical way to gain exposure to commodities than by buying and storing barrels of oil or bushels of corn. Because futures contracts expire, these funds cannot use the in-kind creation and redemption process and must sell contracts for cash to avoid physical delivery.

At year-end, shareholders are responsible for their prorated share of capital gains realized and unrealized (calculated by marking all contracts to market), of which 60% are taxed at long-term rates and 40% at short-term rates. These funds generally do not make distributions, so investors have to pay any tax liabilities out of pocket. Investors should note that many of these funds are structured as partnerships, so instead of receiving a Form 1099, they will receive a Schedule K-1. Because these funds are not structured as 1940 Act funds, we do not have their tax-related data points, such as aftertax returns, and tax-cost ratio on Morningstar.com.

Other categories of funds that invest in futures contracts, and are therefore subject to similar tax rules, are leveraged and inverse funds, alternatives funds, and currency funds. As a side note, investors can avoid these tax issues by investing in exchange-traded notes, which are uncollateralized debt instruments issued by banks that seek to provide the performance of a specific futures index. An example of this is iPath DJ-UBS Commodity Index TR ETN (NYSEARCA:DJP). Because these notes don't actually invest in futures contracts, investors who hold them are not liable for the annual 60%/40% capital gains and simply incur a capital gains or loss, calculated off their cost basis, upon the sale of the ETN.

International Equity ETFs: Not All Dividends Are Qualified
As for international equity ETFs, the ETF structure does not mitigate or eliminate any of the dividend tax complications of its open-end cousins. While international equities tend to be higher yielding than U.S. equities, foreign dividends are considered qualified for the 15% rate only if they are paid by a company domiciled in a country that has a tax treaty with the United States and if the fund has met the holding-period requirement for the stock. Therefore, aftertax returns can be lower than expected. The qualified dividend income, or QDI, percentage can vary from year to year, which reflects changes in holding periods, as well as the effects of representative sampling. As such, the QDI percentage for two ETFs that track the same index, such as iShares MSCI Emerging Markets Index (NYSEARCA:EEM) and Vanguard MSCI Emerging Markets ETF (NYSEARCA:VWO), can be quite different. In addition, some of the dividends are subject to foreign tax withholding in certain countries. (This withheld portion is not included in the funds dividend yield.) Investors can claim their portion of the withheld taxes as a tax credit but only if they hold this fund in a taxable account.

Other Issues That Could Drive Capital Gains
Finally, there are some non-asset class-specific issues that can drive capital gains, although these types of capital gains are fairly uncommon, as they require a specific mix of conditions. As we mentioned earlier, one strategy ETFs' managers use to avoid capital gains is to accumulate realized tax losses. However, if a fund's performance since inception has been consistently strong, any cash transaction, such as a portfolio rebalancing, will likely result in a capital gain. This is more likely for newer funds that track indexes that have higher turnovers, such as small-cap indexes or certain strategy/fundamental indexes. This is also more likely for funds that invest in asset classes that do not allow for in-kind transactions, such as certain emerging-markets countries. Funds that hold emerging-markets small caps have historically generated capital gains because of a combination of redemptions, index rebalancing, and large unrealized capital gains.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.