Keeping an Eye on Leveraged ETF Tax Distributions

It's never too early to start thinking about year-end tax strategies. Granted, taking losses on your portfolio last year was probably quite easy after the S&P dove from around 1,400 in January 2008 to under 800 in November, and perhaps you were able to realize more losses still in March when the S&P fell to 666. But anyone who held through all the turmoil or moved back into the market at the beginning of this rally has a more difficult task keeping the tax man at bay.

Particularly vulnerable are those of us who found some diamonds in the rough anytime between November of last year and April of this year. The rally that has continued ever since has turned junk into treasure, and I know I am particularly excited to part with several of my holdings--but not until I can get favorable long-term capital gains rates. The rub is that I'm nervous that many of my gains will diminish in the not-so-distant future, and my tax strategy will be executed in vain if my favorable tax rates come at the expense of sufficiently lower returns.

But wait I will, because taking short-term gains today results in a known and painful loss, and I still have a fighting chance to keep more of my gains by waiting. This strategy can be implemented across several investment vehicle categories: stocks, bonds, commodities, mutual funds, and ETFs. However, the one small class of investment vehicles that may prove yet again that waiting does not pay is leveraged ETFs.

Over the course of the next few weeks, anyone holding leveraged ETFs (something I wouldn't recommend for most investors, but that's an entirely different discussion) should keep a close eye on their fund provider's Web site for any information regarding upcoming capital gains distributions. While this year's distributions will not likely be as startling as last year's, the situation bears watching.

Anyone who held Rydex Inverse 2X S&P Select Sector Energy (REC) through last December knows how painful distribution time can be. The fund paid out a short-term capital gains distribution equal to about 74% of the fund's NAV. Such a large payout is not only painful from a tax perspective, but it also disrupts a portfolio's structure quite dramatically. In order to cushion the tax consequences, most investors would need to sell their remaining shares following the ex-distribution date at the lower market price to offset the gains, unless they desired paying ordinary income tax rates. If their desire was to maintain their exposure to the energy sector, they then had to go out and purchase a different fund to make up the difference. In short, when the fund providers state that you need to monitor leveraged fund positions on a daily basis, they really mean it.

Those eye-popping distribution numbers came from a 2X inverse sector fund, and we did not have any 3X leveraged inverse funds on the market long enough to discuss distribution at this time last year. Had those funds been around for at least a year, we may have witnessed a situation in which a fund has to distribute all of its assets given the unprecedented volatility witnessed from September through December 2008. While we admit we have limited visibility regarding the magnitude of distributions to come, the circumstances this year lead us to believe that the numbers on average will seem tame this year compared with last.

First, we've witnessed sustained fund inflows into leveraged funds for most of this year. For the 12 months ended October 2009, we estimate that the 146 leveraged and/or inverse funds have seen net fund inflows of $18.7 billion, resulting in nearly $9 billion of total net new assets under management by these funds. (Where did that $9.7 billion difference go?) When ETFs are experiencing net inflows, they become more tax efficient because fewer asset sales must occur to balance out accumulated gains. More often, the tax-efficient creation and redemption process can be used, which utilizes an "in-kind" transaction that can benefit ETF shareholders. In September and October of last year, these same groups of funds experienced net outflows of $2.9 billion on an asset base of roughly $23 billion. Second, because more shares are outstanding today, any taxable distributions will be spread out among more investors. This should blunt the impact that any single shareholder will feel--a case in which sharing the misery has distinct advantages for individuals.

Finally, at least in the case of 3X leveraged-inverse funds, it's hard to generate taxable gains when all that you've experienced are substantial losses. Of the nine Direxion 3X inverse funds following an equity investment, none has produced positive returns since inception. In fact, the best-performing fund of the bunch is down 61%, and the worst has lost an astonishing 94%, based on the data ended Sept. 30, 2009--or less than one year of trading. When Rydex Inverse 2X S&P Select Sector Energy had its 74% distribution, it followed a combination of a 20% price appreciation and significant fund redemptions, which is an issue Direxion has not yet experienced. That's not to say it couldn't happen in the future, because it probably will at some point.

As a side note, of the nine Direxion Bull 3X equity funds, four have lost double-digit percentages over that same time frame, which also coincided with one of the strongest bull-market rallies in history.

 

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