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Year-End Cap Gains for Fixed-Income ETFs

As we ring in the new year--for fixed-income ETFs, cap gains are here.

Abraham Bailin, 12/30/2010

As 2010 draws to a close, shrewd investors are making note of their tax circumstances. While Santa has come and gone, another fanciful visitor is due, the Grinch Internal Revenue Service. With regret, we break the spirit of the season with refrains of the benefits of tax-loss harvesting to maximize gains.

Exchange-traded funds are lauded for many reasons including low costs and liquidity, but as the New Year approaches, the timeliest consideration is the structure's tax efficiency. Compared with their mutual fund counterparts, ETFs generally realize smaller capital gain distributions caused by fund-flow activity of other investors. Uncharacteristically, a number of ETFs in the fixed-income sector have not upheld that industry standard this season. Still, the funds that did in fact see cap gains this year make up a mere fraction of the growing ETF space.

Here, we identify structural differences that allow exchange-traded funds to consistently outperform their open-ended rivals with respect to tax efficiency and consider the reasons that ETFs may not have been able to dodge the tax bullet entirely this year.

Hidden Plumbing: Open-Ended vs. ETF
When open-ended mutual funds create or redeem shares, they do so using cash. Not only does this require the fund to maintain a cash reserve at all times, but it also requires the allocation of realized capital gains to the fund's shareholders. Facing net redemptions, an open-ended mutual fund will sell underlying holdings to pay back shareholders. If those underlying holdings appreciated in value during time that the fund held them (as one would generally hope was the case), then the sale creates a taxable capital gain. Unlike other securities that merely require investors to pay cap gains taxes upon liquidation of the position, mutual funds must allocate accrued tax liabilities to their investors irrespective of whether or not they have sold their shares. Adding insult to injury, open-ended fund investors may have capital gains and tax liabilities allocated to them that were realized before they even invested in the fund. In most cases, even though the ETF is technically an open-end fund, the ETF structure is able to sidestep most of these issues.

ETFs use an "in-kind" creation/redemption process whereby shares are created and redeemed in large bundles referred to as creation-units. ETF providers exchange creation-units (ETF shares) with specialized market makers called authorized participants for assets specified by the fund's methodology. Since this in-kind process doesn't require ETFs to liquidate holdings in the face of net redemptions, capital gains normally are not realized. APs profit by arbitraging ETF shares against the fund's underlying holdings and in return shoulder the cap gains tax burden. This process has proved to provide investors a more tax-efficient exposure. Highlighting this level of tax efficiency, SPDR S&P 500 SPY, the oldest and largest ETF on the market today, has not made capital gains distributions in 14 years.

Coal in the Stocking
There are times, however, when the "in-kind" creation/redemption process is unable to avoid all capital gains recognition. Among the top-five ETF providers, as many as 43 ETFs are expected to declare short- or long-term capital gains distributions for fiscal year 2010. Of those 43 offerings, 38 are fixed-income funds. For a detailed outline of cap gains distributions made by the top providers, please check the table.

The majority of this year's ETF capital gains distributions are mild, most well below 1% of net asset value. Several, however, do stand out. SPDR Barclays Capital Aggregate Bond LAG expects to declare a distribution of 1.43% of its net asset value in capital gains. SPDR Barclays Capital Long CorpTerm Bond LWC expects to make a 1.89% distribution. SPDR Barclays Cap Mortgage Backed Bond MBG expects a 2.02% distribution, and iShares Barclays MBS Bond MBB expects a 2.39% distribution.

It is worth emphasizing that ETF cap gain distributions are the exception, not the rule. The vast majority of exchange-traded funds expect no 2010 year-end distributions whatsoever.PAGEBREAK

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