Emerging-Markets Funds Eye Potential Cap Gains

Many investors know that exchange-traded funds are tax-efficient because of the in-kind creation and redemption process. ETF portfolio managers exchange securities with authorized participants to create and redeem shares of an ETF, and, as a result, ETFs do not typically buy and sell securities and do not generate capital gains often. During index rebalances, ETFs sometimes execute cash transactions (where portfolio managers have to buy the securities that have been added to the index and sell the ones that have been removed), but when possible, portfolio managers are still able to employ in-kind transactions by using custom baskets. It is also important to note that cash transactions do not always result in a capital gain and, in fact, can be used to generate tax losses. While U.S. equity ETFs are generally tax-efficient because of these reasons, emerging-markets ETFs are not always able to employ the in-kind creation and redemption process because a number of countries only allow cash (and not in-kind) transactions.

On June 21, MSCI will announce the results of its 2011 Annual Market Classification Review. Of note are South Korea's and Taiwan's potential reclassifications from emerging markets to developed markets. South Korea and Taiwan account for about 15% and 11%, respectively, of the MSCI Emerging Markets Index, the underlying index for  Vanguard MSCI Emerging Markets ETF VWO and  iShares MSCI Emerging Markets Index EEM. Both South Korea and Taiwan are cash markets, so the removal of one or both of these countries from the MSCI Emerging Markets Index would require a cash sale of VWO's and EEM's South Korean and Taiwanese holdings, which could result in capital gains. In this article, we will discuss in more detail how most ETFs are able to avoid capital gains distributions and why some are not. We will then examine the likelihood of a capital gains distribution for VWO and EEM.

The Big QQQ Rebalance
On April 29,  PowerShares QQQ QQQ was forced to reduce its weight of  Apple AAPL to 12.3% from 20.5% when its underlying index, Nasdaq-100, was rebalanced. If the QQQ sold the Apple shares for cash, the ETF would have likely generated capital gains, given that Apple was trading at all-times highs. While ETFs do employ cash transactions during index changes or rebalances, it can also utilize the in-kind process, which would not generate any capital gains. For example, the portfolio manager of QQQ was able to exchange some Apple shares for equal dollar amounts of shares of  Google GOOG and  Microsoft MSFT and other companies whose weightings were increased in the Nasdaq 100. Another line of defense against capital gains is QQQ's $20 billion tax-loss balance. For illustrative purposes, if we assume QQQ's Apple shares had a cost basis of 0 (because there is no way to estimate what this figure is), the Apple sale as part of the index rebalance would have generated a capital gain of around $2 billion, which would have been handily covered by the tax-loss balance. Out of the 1000-plus ETFs listed in the United States, QQQ had the largest capital loss balance (the next was  SPDR S&P 500 SPY, at $8.3 billion) thanks to its relatively long history, which started in 1999 and included the height of the tech bubble and the subsequent decline.

While an ETF portfolio manager's main goal is to effectively track an ETF's underlying index, another important goal is to avoid capital gains, and one strategy to help accomplish this is to create a tax-loss balance. Out of the 832 ETFs in our database that have a "capital gains realized" data point (which is taken from ETF annual reports), 731 had realized capital losses. Most of these funds are more than three years old and therefore were in existence during the 2008 market crash. As the market declined, at index rebalances, portfolio managers could sell the high-cost-basis securities to harvest tax losses. The remaining 102 ETFs that have realized capital gains could be classified as one of the following: leveraged or inverse ETFs, which hold mostly derivatives, which are settled in cash; fixed-income ETFs, where low interest rates in 2010 resulted in early redemptions, which is a cash event; new ETFs, which do not have a long enough history to build a tax loss balance; and emerging-markets ETFs, which invest in some markets that do not allow in-kind transactions.PAGEBREAK

Why Cash Markets Do Not Always Generate Capital Gains
The larger emerging-markets countries that do not allow for in-kind transactions include Brazil, South Korea, Taiwan, India, and Russia. Many of the funds that track these markets have never had a capital gains distribution. One reason is a large tax-loss cushion--relative old-timer  iShares MSCI South Korea Index EWY's $1 billion tax loss is about equal to the fund's unrealized capital gains, and the $1 billion tax loss of  iShares MSCI Taiwan Index EWT, another relative old-timer, is significantly larger than its unrealized gains of $670 million. Factors that allow portfolio managers to realize tax losses in cash markets are volatile markets and lots of creation and redemption activity--the former provides portfolio managers securities with a wide range of cost basis and the latter provides opportunities to harvest losses.

New ETFs generally do not have a tax-loss cushion, and for ETFs that operate in cash markets, there are a few scenarios that can result in capital gains. In 2010,  Market Vectors Brazil Small-Cap ETF BRF paid out capital gains equivalent to about 5% of net asset value. Since the fund's inception in 2009 through the end of 2010, the ETF steadily appreciated, which did not give the fund's portfolio manager the opportunity to harvest tax losses. If the fund had mostly creations, it would likely not generate a capital gain, but in 2010, BRF saw lots of creation and redemption activity, which triggered capital gains for the ETF. Sister fund Market Vectors Latin America Small Cap Index LATM did not have capital gains because the fund did not have a lot of creation and redemption activity. New small-cap funds are also more susceptible to capital gains especially in a bull market, where, again, portfolio managers do not have an opportunity to harvest losses and where lots of securities can "graduate" from a small-cap index during rebalancing. Funds such as  Vanguard FTSE All-World ex-US Small Cap Index ETF VSS and  SPDR S&P Emerging Markets Small Cap EWX made capital gains distributions in 2010 when they were forced to sell appreciated securities for cash during an index rebalance.

Could VWO and EEM Realize Gains if Taiwan and South Korea Are Moved to Developed Markets?
Unfortunately, it is very difficult to estimate VWO's and EEM's Taiwanese and South Korean securities' cost bases and the potential capital gains. In the table below, we have the realized capital gains (which are tax losses) and unrealized capital gains for both VWO and EEM from their most recent annual reports (Oct. 31, 2010, for VWO and Aug. 31, 2010, for EEM). While this information is stale at this point, we can make the following simple analysis. VWO's tax-loss balance of $1.9 billion would cover a 16% or lower capital gain from the sale of the fund's Korean and Taiwanese securities, whereas EEM's tax loss of $2.7 billion would cover 27%. This suggests that EEM is in a better position (at the time of each fund's annual report) to realize less potential capital gains relative to VWO. EEM is also carrying a significantly smaller unrealized capital gain of negative $0.2 billion, versus VWO's $8.7 billion. While there is no way to know how much of this unrealized gain or loss is attributable to Taiwanese and Korean securities, with a slightly negative unrealized loss, EEM has more potential to harvest tax losses, relative to VWO. However, EEM saw a net redemption of $9.7 billion in the first quarter of 2011, when EEM was trading near all-time highs (it traded higher in the second half of 2007 and the first half of 2008). This net redemption could have significantly changed EEM's realized and unrealized balances.