When ETFs Aren't Tax-Efficient

Exchange-traded funds are growing in popularity for a number of reasons, but one of the biggest is their tax efficiency.  SPDRs (SPY), the oldest such fund, has not paid a capital gains distribution in the past 10 years. However, not all ETFs are so gentle on the tax bill. This year, six leveraged or short ETFs have paid out short-term capital gains distributions of 3% to 7% (yikes!) of their market value, and the past couple years have seen similar tax liabilities. To explain why these funds in particular keep 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. 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.

For example, say that SPDR S&P 500 has a large stake in  Exxon Mobil (XOM) dating back to the 1990s with its cost basis around $40 per share and is currently facing net redemptions. Instead of selling those shares of Exxon and taking a huge capital gain, SPDR S&P 500's 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, 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.

However, this tax efficient process relies on trading marketable assets with the authorized participants. 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&P 500 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.

2008 ETF Short-Term Capital Gains Distributions
	Ex. Date	ST Cap Gains	Prev. Close	% Close
Ultra Oil & Gas ProShares (DIG)	03/25/08	$4.296	$88.72	4.8
Ultra Basic Materials ProShares (UYM)	03/25/08	$6.000	$82.20	7.3
UltraShort MSCI Emerging Mkts ProShares (EEV)	09/24/08	$3.399	$105.25	3.2
UltraShort Oil & Gas ProShares (DUG)	09/24/08	$1.804	$38.33	4.7
UltraShort Dow 30 ProShares (DXD)	09/24/08	$3.647	$66.65	5.5
UltraShort S&P 500 ProShares (SDS)	09/24/08	$3.826	$73.48	5.2

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.

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