By Robert Godsborough
For investors, one of the most appealing aspects of exchange-traded funds is their clear tax efficiency.
To start with, many passive funds inherently are low-turnover vehicles, with a minimal amount of concentrated buying and selling of specific securities. In addition, because ETFs have the ability to redeem securities in-kind, their managers often can dodge the capital gains bullet by swapping out low-cost-basis securities without having to realize large amounts of capital gains, if any.
However, ETFs are not 100% immune. For a variety of reasons, ETFs can, on occasion, issue capital gains distributions. As 2014 rapidly comes to a close, major ETF providers have begun announcing estimated capital gains distributions for the year. And once again, ETF sponsors anticipate capital gains distributions from just a small minority of funds.
At the seven large ETF providers that have published estimates thus far--iShares, Vanguard, State Street, Schwab, PIMCO, Guggenheim, and First Trust--just 74 out of 712 funds are facing capital gains distributions of any kind, whether long-term or short-term, according to the providers' estimates. And in many cases, the distributions are very small--far less than 1% of the affected ETFs' net asset value. That's a far cry from the 5% to 10% capital gains distributions that some equity mutual funds have announced in recent weeks.
Where Capital Gains Distributions Tend to Occur
Many plain-vanilla ETFs that are not in the fixed-income arena and that do not hold exotic securities do not pay capital gains distributions. Cap-weighted equity ETFs in particular often experience turnover only at the margins and thus keep their trading to a minimum.
It's not always easy to generalize the kinds of ETFs that issue capital gains distributions. However, for the most part, ETFs that could be expected to issue a capital gains distribution are ones that trade heavily, use futures contracts (such as leveraged or inverse ETFs), undergo a dramatic change in their underlying indexes, or hold fixed-income securities, as bonds mature regularly and thus must exit a portfolio (stocks, by contrast, have no maturity date). In a falling-rate environment, bonds that age out of a portfolio have done so after appreciating in value, forcing an ETF manager to sell those bonds at a gain. In addition, ETFs in asset classes that have done especially well are sometimes more prone to issuing capital gains distributions.
What's Happening This Year?
This year, several important dynamics have been at work in triggering capital gains distributions for ETF investors. One is in the fixed-income arena. As historically has been the case, most large ETFs issuing capital gains distributions of any size are bond ETFs. However, bond ETFs' capital gains distributions are for the most part fairly minimal. For instance, the estimated capital gains distribution for one of the largest bond ETFs, iShares Core U.S. Aggregate Bond (NYSEARCA:AGG), is just about 0.10% of its net asset value, while the estimated distribution for the other bond titan, Vanguard Total Bond Market (NYSEARCA:BND), is a slightly higher 0.27% of NAV. Based on the structure of the bond market and the fact that bond issues regularly mature, we expect fixed-income ETFs always to be at least at risk of generating small capital gains distributions.
The table below depicts the five largest ETFs that thus far have announced capital gains distributions, four of which are bond ETFs. Note that these figures are all estimates; the actual percentage of NAV distributed will vary.
However, It's Not Just Bond ETFs ...
ETF investors in several other corners of the market are likely to see capital gains distributions as well, including currency-hedged equity ETFs and one frontier-markets ETF.
First, a stronger dollar this year relative to some other currencies has been behind some sizable capital gains distributions that are expected to be generated by several currency-hedged ETFs. In fact, the dollar recently hit its strongest level in two years against the euro. As a result, during the last year, managers have had to book a gain as they rolled their currency futures and forward contracts. These contracts used in hedges cannot be traded in-kind, which increases the likelihood of a capital gain.
Any ETF whose index undergoes a dramatic shakeup because of changes in classification is at risk of issuing a capital gains distribution. That was the case this past year for iShares MSCI Frontier 100 (NYSEARCA:FM). The fund's index provider, MSCI, recently upgraded Qatar and the United Arab Emirates from frontier-markets to emerging-markets status. As a result, during the past five months, FM has tracked a transition index as it has gradually shed its holdings from those two countries, which had comprised some 40% of the fund. MSCI currently does not have any countries under review, which suggests that there won't be a significant index change (because of a change in country classification) in the near term.
Some ETFs that issue large capital gains distributions are ones that are devoted to certain corners of the market that have done especially well during the past several years, such as small-cap stocks and U.S. health care and biotechnology. However, on the open-end mutual fund side, some of the funds devoted to those areas of the market have projected capital gains distributions that are even higher. For example, funds such as American Funds SMALLCAP World (MUTF:SMCWX), T. Rowe Price Science & Technology (MUTF:PRSCX), T. Rowe Price Global Technology (MUTF:PRGTX), T. Rowe Price Health Sciences (MUTF:PRHSX), and Fidelity International Small Cap (MUTF:FISMX) all are expected to pay capital gains distributions of between 9% and 11% of NAV.
Below is a table that lists the 10 largest projected capital gains distributions from those ETF providers that have published estimates thus far.
Breakdown by Firm
At the ETF provider level, the estimated capital gains distribution activity this year is not especially different from past years. Once again, the largest ETF provider, iShares, posted a strong year for tax efficiency, with estimated capital gains distributions on 16 of the firm's roster of 298 ETFs. That's a higher percentage than last year (when iShares registered capital gains on just four of its roster at that time of 299 ETFs), but it's still very low. Vanguard anticipates a slightly higher percentage of capital gains distributions than iShares relative to its product lineup, projecting capital gains distributions on nine of its 67 ETFs (all nine are bond funds). However, that's in line with where Vanguard historically has been (last year, for example, Vanguard announced capital gains distributions on eight of its 67 ETFs.
As in the past, State Street is anticipating capital gains distributions for a higher percentage of its ETFs than other ETF providers. This year, 27 of the firm's 144 ETFs, or 19%, are expected to issue capital gains distributions. That's up from 19 out of State Street's 124 ETFs last year. In addition, many of the same funds that are issuing capital gains distributions, such as SPDR S&P Dividend (NYSEARCA:SDY), SPDR S&P Pharmaceuticals (NYSEARCA:XPH), and SPDR Russell Small Cap Completeness (NYSEARCA:RSCO), did so last year as well.
In the second tier of providers, PIMCO, which has been in the news a lot this year, is expecting fairly small capital gains distributions on seven of its 17 ETFs (PIMCO Total Return ETF (NYSEARCA:BOND) is not one of those, although the Bronze-rated mutual fund PIMCO Total Return (MUTF:PTTAX) is anticipating a small capital gains distribution).
Schwab expects to pitch a shutout, with none of its 21 ETFs projected to issue capital gains distributions. That's in keeping with Schwab's history--the firm issued no capital gains distributions last year, either--although Schwab's ETFs also are less likely to be heavily used by traders, given the firm's model of focusing on core portfolio building blocks and its funds' relative lack of liquidity.
Meanwhile, First Trust also is anticipating mostly goose eggs, projecting that none of its 92 ETFs will issue any long-term capital gains distributions and only very minimal, if any, short-term distributions. Finally, Guggenheim posted the highest percentage of any firm, with capital gains distributions expected on 16 of its 73 ETFs. However, all but one of those are target-maturity corporate-bond ETFs that Guggenheim has rolled out during the past few years.
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