The Wall Street Journal-20080116-ETFs Harbor a Little Surprise- Capital Gains for the Tax Collector
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ETFs Harbor a Little Surprise: Capital Gains for the Tax Collector
ETFs are tax-efficient, except when they're not.
Rapid growth in the exchange-traded-fund business, and the increasing complexity of many new ETFs, is making it harder to achieve the industry's goal of tax-friendliness for investors.
By December, it was clear some ETFs would pass along substantial capital gains to shareholders, likely prompting tax bills in some cases. Now with 2007 in the books, it's possible to get a more complete picture.
Last year, 95 ETFs, or nearly 18% of all exchange-traded funds tracked by fund researcher Morningstar Inc., passed along capital gains to investors. That's a big jump from just 6% of ETFs in 2006 and 3% of ETFs in 2005.
The shift comes as the exploding growth of the ETF industry is prompting complaints about some aspects of the popular funds. ETFs are index funds that trade on an exchange like a stock, and they made their name as straightforward, low-cost investments. But critics, including fund analysts and some high-profile investors, have previously said some new funds are gimmicky and unnecessarily expensive.
Until recently, however, not even critics of ETFs have questioned their tax advantages, which remain a favorite marketing refrain of the ETF companies.
Capital-gains distributions affect investors like this: Holders of mutual funds or ETFs don't just pay tax on their gains when they sell fund shares. Uncle Sam also requires them to pay up on trading profits the funds earn each year. The top federal tax rate on long-term capital gains is 15%. For short-term gains, it's 35%.
Because of the unique way ETFs create and redeem fund shares, ETF fund managers can eliminate many capital gains before they are required to distribute them to the funds' investors.
To be sure, many of the ETFs' 2007 distributions are tiny -- some as little as a fraction of a penny a share. But other distributions are significant. Among the biggest: ProShares Ultra Oil & Gas passed out gains amounting to about 6% of its assets to shareholders, while Rydex S&P Equal Weight Industrials ETF distributed gains equal to 3.2%.
Of the 95 funds that made distributions, 47 passed along gains equal to 1% or more of assets.
One percent is the threshold that one ETF analyst, Morningstar's Jeffrey Ptak, recently said he "wouldn't be too happy" to see crossed.
Newer funds -- those launched in 2006 or 2007, after the ETF business began to explode in size -- were three times more likely to pass along capital gains than older funds, data from Morningstar show.
There are several factors behind the dynamic, ETF fund companies say. Newer funds tend to be thinly traded, which makes it more difficult for managers to maneuver their holdings in order to avoid recognizing gains.
In addition, many funds that appeared in the past two years invest in just a small sliver of the stock market. Owning fewer stocks makes these funds more volatile than their broader predecessors, which can lead to eye-popping gains and losses. The gains can translate into distributions.
Finally, some new funds offer investors complicated strategies such as magnifying returns of a stock-market index. These strategies require managers to invest in exotic instruments such as futures contracts and swap agreements that follow different tax rules than stocks.
"ETFs are not 100% immune" from capital gains, says Barclays PLC spokeswoman Christine Hudacko. "We've got so many ETFs replicating so many slices of the market," managers can't always compensate for big run-ups or "corporate actions" like mergers that can oblige them to record gains.
Many conventional mutual funds also passed out hefty capital gains in 2007, a year that capped five straight years of healthy stock- market returns. In some cases, these distributions amounted to 10% or more of fund assets, dwarfing those made by ETFs.
