Why an upgrade of Korea and Taiwan to developed markets could generate capital 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
The Big QQQ Rebalance
On April 29, PowerShares QQQ
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.
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
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
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.
If MSCI were to announce later this month that Taiwan and Korea would be reclassified as developed markets, the index change would occur about one year later, which gives the portfolio managers of EEM and VWO time to adjust the portfolios to minimize potential capital gains. Both funds already employ sampling and derivatives to track the index and can use these strategies, combined with tax-loss harvesting, to try to accumulate a tax-loss balance that would offset a potential capital gain. However, despite VWO's and EEM's portfolio managers' best efforts, unpredictable market movements and creation and redemption activity leading up to a rebalance could make it impossible to avoid capital gains.