The Tax Man Cometh for Leveraged and Inverse ETFs

As year-end approaches, prudent investors have begun thinking about tax harvesting and other strategies to maximize the money they keep and limit Uncle Sam's take. Therefore, we thought it would be an appropriate time to scan the ETF landscape to see what's on the horizon in terms of expected capital gains distributions for 2008. Overall, traditional ETFs continue to boast exceptional tax efficiency; however, a few leveraged funds have managed to grab headlines by sticking investors with sizable tax bills. Though some warts of the ETF structure have been exposed amid the violent volatility and unprecedented market events of 2008, a few "bad apples" shouldn't taint investors' perception of the ETF industry as a whole. To explain why leveraged and inverse funds in particular are producing taxable capital gains while other ETFs seem to dodge them year after year, we first need to delve into the legal structure that makes ETFs so unique.

Traditional open-end mutual funds create or redeem shares for cash, which requires the fund to always carry a cash cushion. Even open-end passive index funds need to sell some of their holdings if they face net share redemptions, which can incur capital gains. (This will undoubtedly cause a considerable outcry from investors, considering the sharp losses many mutual funds have incurred this year, but that's a topic for a different article.) ETFs instead create and redeem shares in large bundles called creation units, which can be swapped directly for the assets (stocks, bonds, futures, etc.) in the ETF's portfolio by major banks or trading firms called authorized participants. This unique share creation process gives ETFs their extreme tax efficiency. (Click here to view a helpful diagram provided by NASDAQ that details this process.)

The unique creation and redemption process is the reason that most traditional ETFs continually dodge the cap-gains tax bullet. For instance,  SPDRs (SPY), the oldest such fund, has not paid a capital gains distribution in the past 10 years. Consider that SPDRs has a large stake in  ExxonMobil (XOM) dating back to the 1990s with a cost basis of around $40 per share. Hypothetically, let's say the fund is currently facing net redemptions. Instead of selling those shares of Exxon and taking a huge capital gain, SPDRs' managers can take those shares with the lowest cost basis and give them to authorized participants in exchange for redeemed creation units, thus shifting the unrealized capital gains away from the fund and onto the market makers who buy up and redeem ETF shares. Through this process, an ETF can continually increase the cost basis on the assets in its portfolio. Even if it were forced to eliminate a holding because of a change in the index, the fund could sell off any shares it holds at a high cost basis without incurring capital gains, and then keep a small position for as long as it takes to shift the rest of its low cost basis shares off to authorized participants. Thus, ETFs can avoid most capital gains even while changing portfolio holdings by accepting some minor tracking error against their index.

The effectiveness of this process is evident among the traditional ETF providers. For instance, industry leader  Barclays (BCS) expects to pay out year-end capital gains distributions for just two of its 178 iShares ETFs, and those distributions are negligible in size.  State Street Corporation (STT), best known for its SPDRs lineup, is also distributing negligible capital gains on just three of the more than 80 ETFs that it offers.  Invesco's (IVZ) PowerShares family of dynamic and quantitative active funds proved that even portfolios with relatively high turnover can still be extremely tax efficient. Only one out of the firm's 120 funds is slated to pay out a capital gains distribution, and even that is minimal. PowerShares S&P 500 BuyWrite (PBP) is expected to pay out a short-term capital gains distribution of just $0.05 per share (about 0.30% of the fund's NAV as of December 2). We don't think investors will have any qualms about this tiny tax nibble, as the PowerShares ETF has outperformed the S&P 500 by more than 10 percentage points since its Dec. 20, 2007, inception. Similarly,  Market Vectors Steel ETF  is the only fund from the Van Eck lineup of ETFs that is expected to pay out capital gains this year. Traditional ETF providers Vanguard and WisdomTree, which manage 38 and 41 ETFs, respectively, expect to distribute no capital gains distributions this year.

ETF providers that specialize in leveraged and inverse funds, namely ProShares and Rydex, didn't fare as well as their traditional counterparts, at least on the tax efficiency front. While six of ProShares' 76 ETFs are expected to pay out distributions this year, the amounts pale in comparison with the eye-popping distributions expected from a few Rydex ETFs. Particularly standing out was Rydex Inverse 2x S&P Select Sector Energy (REC), which paid out a short-term capital gains distribution equal to about 74% of the fund's NAV. We should mention, however, that investors who held the fund since inception enjoyed a return of more than 20% to cushion the blow. Matt Hougan over at Indexuniverse.com recently published an informative piece on this topic. Also, please view this table for a complete summary of expected capital gains distributions from each of the ETF providers, some additional information on the ETFs that are expected to pay out distributions, as well as links to the related press releases from the respective firms.

So, why do these leveraged exchange-traded products tend to be less tax efficient than their traditional counterparts? Unlike other ETFs, leveraged and short ETFs do not use a portfolio of exchange-traded assets to track their benchmark index. Instead, they keep their assets in a pool of cash and enter custom swap agreements to produce the desired returns. This means that when authorized participants create or redeem new shares of  UltraShort S&P500 ProShares (SDS), they merely exchange the shares for a set amount of cash. Generally, this still does not incur large distributions. The pool of cash produces interest income that needs to be paid out to shareholders quarterly, but it rarely exceeds 1% of assets. However, if the fund goes into net redemptions and starts to shrink in assets, the managers must sell some of the derivatives they used to replicate their benchmark instead of passing them off to the authorized participants. As the distributions of six ETFs this year show, that can lead to some hefty capital gains payments for the shareholders remaining in the fund.

This is not a reason to avoid short and leveraged ETFs, but it is a reason for caution. These funds still have the trading advantages of liquidity, timeliness, and low commissions just like every other ETF. They still provide hedging and speculative opportunities that are otherwise inaccessible to the individual investor. They do not possess the impressive tax advantages of most ETFs, but they should still perform no worse than a traditional open-end mutual fund on this point. Also, though many funds have already made their distributions, nimble traders can avoid some of the tax bite by dumping their shares ahead of the posted ex-date.

 

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