Year-End Cap Gains for Fixed-Income ETFs

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.

Possible Triggers
Factors outside of the creation/redemption procedure may, at times, outweigh the effectiveness of the in-kind process by which ETF shares are created. Let's consider, for example, MBB, which provides investors exposure to a basket of mortgage-backed securities. Mortgage rates dropped to historic lows during the year, prompting a host of refinancing activity. As homeowners paid back existing mortgages, MBSs held by the exchange-traded fund may have been effectively caused to expire early, creating cash redemptions--not by holders of the ETF shares but within the portfolio of the fund itself. The in-kind creation/redemption process by which the fund's holdings are normally added to or removed from the portfolio has no effect on capital gains accrued in this fashion, which may explain why MBB and MBG do in fact have such high expected cap gains distributions for 2010.

Investors should note that within similar segments of the fixed-income ETF space, there are factors that will lead to varying cap gains exposure.  IShares Barclays Aggregate Bond (AGG),  Vanguard Total Bond Market ETF (BND), and LAG all track the Barclays Aggregate Bond Index. While historically all three have remained highly tax-efficient, this year their listed distributions are 0.25%, 0.44%, and 1.43% of NAV, respectively. While the three funds track the same index, they do so using different sampling methods. The Barclays Aggregate Bond Index tracks more than 8,000 bonds; the ETFs hold only a fraction of the index. BND maintains 5,000 holdings, AGG holds 690, while LAG includes only 363. The varying sampling methods can lead to different levels of exposure to various types of fixed-income securities. The index that these funds share covers the broad bond space, and sampling methods leading to varying subsector weightings may result in lower incidence capital gains distributions. Additionally, shifts in each ETF's sampling basket, while aiming to minimize tracking error, could create the potential for cash transactions and a possible capital gain that varies based on the sampling method.

Fixed-income ETFs will generally face a number of issues that their equity counterparts do not. Funds holding a diversified basket of equity securities do not necessarily need to shift holdings on a routine basis to maintain their exposure. Fixed-income ETFs, on the other hand, hold securities whose expiration dates draw ever closer and may need to be adjusted accordingly. Additionally, funds may find tax-loss harvesting difficult in the fixed-income space. Unlike a diverse basket of equity securities, government bonds generally exhibit high levels of cross-correlation. The fixed-income sector went on a tear recently, which may have caused inconsistencies in redemption of shares as bonds were priced up.

While external forces may modify the effectiveness of the in-kind process at times, capital gains distributions that ETFs do realize are few and far between. When such gains are seen, if nothing else, they tend to be less than competing open-end funds. ETF investors should place this year's cap gains distributions into context. The ETF structure still provides the lowest incidence of capital gains distributions among products offering similar exposures. That in itself should be enough to add a little extra holiday joy to those wise enough to see that the glass is half full, not half empty.