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Be Ware Of ETF Distributions

|Includes:EEM, Vanguard FTSE Emerging Markets ETF (VWO)
Obviously, I'm a big fan of exchange traded products and I don't mince words about those feelings, but like almost everything else in this world, ETFs are not perfect. Hence, just two months removed from paying Uncle Sam my 2010 tax tab, I'm bringing up the issue of ETF distributions today.

Distributions are supposed to be and are for the most part, the primary advantage of owning ETFs over mutual funds. When a mutual fund manager sells a stock at a profit, the capital gains tax on that profit is passed on to you, the investor. That's a bad deal, particularly when considering that most mutual funds often feature much higher fees than comparable ETFs.

Unfortunately, taxable distributions are a fact of life in the ETF universe as well. At the end of May there were above 1,230 ETFs and ETNs trading on U.S. exchanges and I'd venture to say, albeit unscientifically, that the vast majority, probably in the neighborhood of 70% to 75% give or take a few percentage points, don't subject investors to taxable distributions.

As I am so fond of saying the devil is in the details and this is a situation that can be avoided with just a few minutes of homework because essentially every ETF that MIGHT subject investors to taxable distributions makes note of this fact in the fund's prospectus. Again, ETF prospectuses aren't the most exhilarating reads on the shelf, but reading them does help your pocketbook.

There is another way around the ETF distribution situation, though I can't say I'm a big fan of it. If you are subject to a big distribution, say 25% or more, the fund's net asset value should drop by the same dollar amount and if you bail-out of that ETF before the end of the year, the loss you've absorbed should offset the distribution.

I also thought it was timely to bring up the issue of ETF distributions because two of the most popular ETFs on the market could be subject to distributions very soon. MSCI, the company that provides indexes for tons of ETFs, is expected to announce market reclassification on Tuesday evening, meaning some emerging markets could be promoted to developed market status.

This is an issue shareholders in the Vanguard MSCI Emerging Markets ETF (NYSE: VWO) and the iShares MSCI Emerging Markets Index Fund (NYSE: EEM), two of the most popular ETFs on the market as ranked by assets under management, need to be aware. Why? Glad you asked.

The reason is simple. South Korea and Taiwan, each of which combine for over 26% of the country allocations in both EEM and VWO, could very well be promoted to developed market status. If that happens, and I emphasize if as I am writing this well advance of the MSCI release, iShares and Vanguard will be forced to sell South Korean and Taiwanese stocks. Those are both cash markets and that sets investors up for a potential taxable distribution.

Now I'm not saying run out and sell EEM or VWO just because of the distributions. Frankly, I think these two ETFs could become more attractive if they fill the gaps created with the loss of South Korea and Taiwan with countries like Colombia, Poland and Russia. That's just my two cents. In the meantime, endure the distributions in the case of EEM and VWO and make it a note to avoid them in the future.

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Stocks: VWO, EEM