ETFs are said to be more tax efficient than mutual funds because they are less likely to distribute capital gains (which are taxablewhenreceived in a taxable account). Why are they less likely to distribute capital gains?
- ETFs passively buy and hold the basket of stocks in an index, so there is low turnover in portfolios and hence low realization of capital gains
- ETFs don’t have to sell securities to redeem units (unitholders can simply sell their units on the stock exchange to other investors)
- redemption requests from authorized participants (who arbitrage differences in net asset value and market price) are met by transferring stocks (not a taxable transaction)
- ETFs can give the authorized participants stocks with the highest unrealized gains in their portfolio, thereby reducing the potential for distributing gains to unitholders
This greater tax efficiency is said to be one reason why ETF sales continued to grow during the bear market while mutual funds were experiencing heavy redemptions. Many mutual fund holders were facing hefty capital-gains distributions and decided to avoid themby selling their funds and buying ETFs tracking the same market.
Still, ETFs have been known on occasion to distribute capital gains to their unitholders. For example, the iShares CDN Tech Sector Index ETF ( XIT) last year distributed a capital gain of $0.80 per unit, or about 20% of the price. What then are the risk factors? What ETFs are more likely to surprise unitholders with hefty capital-gains distributions? Here are some considerations:
1. ETFs tracking indexes with a lot of turnoverhave more potential for selling stocks with capital gains.
2. Newer ETFs pass along capital gains more than older ETFs because they tend to track smaller slices of the marketand have fewer liquid stocks (so there is greater volatility in prices and thus greater potential for bigger and/or more frequent capital gains/losses).
3. Inverse and leveraged ETFs (particularly smaller ones) use derivatives (like options and swaps), which dont lend themselves well to “in-kind” redemptions(so if a market maker delivers a block of units to the fund company, the company must sell some of their derivatives to raise cash to pay the market maker).
4. Some ETFs with substantial capital-gains distributions give their unitholders several days to sell beforethe date of record and thereby avoid the distributions (like Ryders).
5. Some ETFs with substantial capital-gains distributions dont givetheir unitholders any time to sell before the date of record (like ProShares).
6. During bullish markets, ETFs will tend to have more capital-gains distributions because turnover in index escalatesdue to mergers, acquisitions and spin-offs plus, indexes with caps on the size of individual stock holdings are often compelled to pare back positions when they bump up against their caps.
7. Established, broad-based ETFstend to have very few distributions and fare much better than index mutual funds.
8. Changes in an ETFs mandateand the movement of stocks between small, mid, and large cap strata can trigger distributions.