The strengthening dollar in 2016 means that currency hedging is once again the tax villain for ETF investors.
Welcome to December, the time of year when investors cozy up next to the fireplace with hot cocoa to reflect on the year, resolve to better themselves, and evaluate the tax consequences of their investment decisions.
Investors in exchange-traded funds can be thankful that these funds' structure is, generally speaking, more tax-efficient than traditional open-end mutual funds. As Morningstar ETFInvestor editor Ben Johnson discussed in "Declare the Pennies on Your Eyes" in the November 2015 issue, ETFs' inherent tax efficiency has two primary sources: 1) strategy and 2) structure.
Because most ETFs track indexes, they typically have a far lower level of turnover relative to actively managed funds. Lower turnover equates to a lower likelihood of unlocking taxable capital gains. ETFs also possess important structural advantages over traditional open-end mutual funds. ETFs can use in-kind transfers of portfolio securities instead of cash to meet redemptions. Using in-kind redemptions, ETFs can sidestep realizing capital gains. But this doesn't mean ETF investors are immune from capital gains distributions.
Most of the ETFs that are projecting capital gains distributions for 2016 exhibit one or more of the following characteristics:
Aside from a handful of ETFs falling into one or more of these buckets, 2016 capital gains distributions from ETFs will be few and far between.
2016's Capital Gains Culprits
Through early December 2016, 11 major ETF sponsors had published year-end capital gains estimates. Those fund families include BlackRock/iShares, Vanguard, State Street Global Advisors, Schwab, PowerShares, First Trust, WisdomTree, VanEck, Guggenheim, Deutsche X-Trackers, and PIMCO. Collectively, these firms sponsor a combined 1,120 ETFs, of which 86 (7.7%) are projected to distribute capital gains this year. Only 22 of these 86 ETFs estimate capital gains distributions amounting to more than 2% of their net asset value as of Nov. 30.
Currency-hedged ETFs are once again the tax villains this year, owing to the strengthening U.S. dollar. To hedge foreign exchange fluctuations, these funds' portfolio managers must roll forward currency derivatives contracts on a regular basis. These derivatives cannot be redeemed in kind. Thus, the tax consequences of any gains in these positions are passed on to investors in the fund. This year, currency-hedged ETFs represent 14 of the 22 ETFs with projected capital gains distributions amounting to more than 2% of their NAV. Eight of these 14 funds also rank amongst the top 10 capital gains distributors as ranked by this same measure.
Table 1 displays the top 10 ETFs ranked by their estimated capital gains distributions as a percentage of their NAV. It is important to note that all of the capital gains figures throughout this article are estimates and the actual values may change. To compare distributions more consistently, I calculated estimated capital gains as a percentage of each fund's Nov. 30, 2016, NAV.
This year's largest capital gains distributor, iShares Edge MSCI Minimum Volatility Asia ex Japan AXJV, invests in stock markets in China, South Korea, Malaysia, and Taiwan. These markets don't allow in-kind redemptions. Because these markets are cash-settled, ETF providers can't use their best tax-management tool. Elsewhere, the tax consequences of currency-hedging gains will be borne by shareholders of those ETFs ranked second through ninth in Table 1. Meanwhile, SPDR DoubleLine Emerging Markets Fixed Income EMTL was doubly disadvantaged as a fixed-income ETF that invests in markets that restrict in-kind redemptions.
Which Big ETFs Are Expecting Capital Gains?
Most of the ETFs expecting hefty capital gains distributions are newer funds with fewer assets. As such, these distributions will affect a smaller number of investors. Which funds will distribute gains that will have the most widespread impact? Table 2 shows the largest ETFs--as measured by assets under management--that are projecting capital gains distributions. Fixed-income ETFs dominate the list, but their estimated capital gains distributions are quite small, typically amounting to less than 1% of these funds' NAV.
Eight of the 10 largest ETFs expected to distribute taxable capital gains this year also distributed capital gains last year. The two ETFs that are new to Table 2 in 2016 are SPDR Nuveen Barclays Short-Term Municipal Bond ETF SHM and SPDR DoubleLine Total Return Tactical TOTL. Until this year, SHM had avoided distributing capital gains since 2013. TOTL launched in February 2015 and has seen steady inflows since its inception, so it's not surprising that it didn't distribute any capital gains. But the active nature of its strategy and any potential outflows could increase turnover and thus the likelihood of future capital gains distributions.
ETF Sponsor Report Cards
From an ETF sponsor perspective, those with the most currency-hedged or fixed-income offerings have the greatest number of ETFs expected to distribute capital gains. Table 3 shows the number and percentage of ETFs in each sponsors' lineup that are expecting capital gains distributions, as well as some figures showing the magnitude of their distributions and the makeup of the funds expecting to throw off gains.
BlackRock/iShares and State Street Global Advisors, the firms with the largest ETF lineups, each estimate 21 of their ETFs will issue capital gains. That represents 6% of all BlackRock ETFs and 14% of all State Street ETFs. Last year, State Street estimated that 23% of its ETFs would distribute capital gains, so its lineup has moved in the right direction. Most of BlackRock's ETFs estimating capital gains are currency-hedged or fixed-income focused. Deutsche X-Trackers led the pack with a fourth of its 39 ETFs predicting distributions. Most of these are currency-hedged ETFs launched in the past few years.
Vanguard projects eight of its ETFs will issue capital gains. All eight are fixed-income ETFs. VanEck and First Trust have a small number of ETFs estimating capital gains. VanEck estimates that the same two funds from its 62 ETF lineup that distributed capital gains last year will do so again this year. The China-focused VanEck Vectors ChinaAMC CSI 300 ETF PEK and a high-yield bond ETF, VanEck Vectors Fallen Angel High Yield Bond ANGL will again pass on capital gains to their shareholders in 2016. First Trust predicts that only two of its 114 ETFs will distribute capital gains.
WisdomTree distributed capital gains from 17 of 83 funds last year, but this year it estimates only nine of its 93 ETFs will issue capital gains. Once again, Schwab predicts that none of its 21 ETFs will distribute capital gains this year. Schwab launched its first ETFs in 2009, and according to Morningstar Direct data, none of its ETFs has ever issued a capital gains distribution. This is likely because its ETFs track passive, market-cap-weighted indexes and have generally experienced steady inflows since their inception.
Root Cause Analysis
There are several characteristics that make some ETFs more prone to distributing capital gains. For instance, ETFs that use derivatives in currency-hedged, inverse, or leveraged strategies must periodically reset those derivatives and recognize the associated gains (or losses, as the case might be). Fixed-income funds are also more susceptible to generating capital gains. This is because the bonds in their portfolio will naturally mature, which can result in the recognition of a gain in the case that the bond was added to the fund's portfolio at less than par value.
Emerging markets are another tricky area because some foreign markets ban in-kind redemptions, which can have a crippling effect on tax efficiency. Also, funds that change their underlying index (which increases turnover) and those that represent a market that has performed particularly well are more vulnerable to capital gains distributions.
Understanding why ETFs may generate capital gains can help investors better navigate this tax minefield. Most ETFs, especially those tracking broadly diversified, market-cap-weighted benchmarks, are very tax-efficient. That said, as ETF sponsors move beyond the realm of plain-vanilla, investors should scrutinize newer, more-complex ETF offerings to avoid unpleasant tax consequences.
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