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ETFs Again Proved Their Worth to Taxable Investors in 2020

Most avoided capital gains distributions this year.

Capital gains season is here, and exchange-traded fund investors once again have reason to celebrate. Most ETFs will not be making capital gains distributions in 2020.

To date, 12 of the largest ETF sponsors--which together manage 95% of the $5.2 trillion invested in ETFs--have reported estimated capital gains distributions for their funds. These 12 firms back a total of 1,392 ETFs, representing 61% of the 2,285 ETFs available to investors as of Dec. 10, 2020. Among these 1,392 ETFs, just 70 (5%) will distribute capital gains to their investors this year. The impact of these distributions on investors’ tax bills will generally be small, as 59 of the 70 (84%) of the funds spinning off gains will make distributions that amount to less than 1% of their Nov. 30 net asset values.

Fixed-income ETFs are typically less tax-efficient than stock ETFs. This year was no exception. Taxable- and municipal-bond ETFs represent 80% of the ETFs within this sample that will distribute capital gains in 2020. Roughly one fifth of all the taxable-bond ETFs in this sample are expected to distribute capital gains in 2020.

Falling interest rates and rising flows are two key factors explaining bond ETFs’ 2020 distributions. As rates went down, the prices of the bonds in many of these funds’ portfolios went up. And as investors piled into bond ETFs, the funds’ portfolio managers had fewer opportunities to purge gains from their portfolios through in-kind redemptions. This was particularly challenging for managers of maturity-bracketed bond funds--those focused on the short-, intermediate-, or long-term segments of the yield curve. As long-term bonds approach maturity and become intermediate-term bonds and so on, portfolio managers must often sell these positions or hold them until maturity. This can result in realized capital gains--especially in a year when interest rates have declined.

Only a dozen equity ETFs among the 896 backed by this group expect to spit out capital gains, just 1.3%. Those sending out gains to shareholders were affected by many of the same issues that have driven distributions by stock ETFs in years past. The specifics differ from fund to fund. The common thread is that these funds are often unable to use in-kind redemption to push low-basis stocks out of their portfolios.

Small Gains What little tax pain ETF investors might feel in 2020 will likely be dull. Just 11 of the 70 funds that expect to distribute capital gains anticipate they will be greater than 1% of the funds' Nov. 30 net asset value. Exhibit 2 shows the 10 ETFs expecting the largest distributions. VanEck Vectors China Growth Leaders ETF GLCN is an outlier. This tiny fund has experienced big outflows in 2020. The $30 million that fled the fund through November represented nearly 45% of its end-2019 assets. Given that stocks listed in mainland China cannot be redeemed in kind, the portfolio managers were forced to sell securities to fulfill redemptions and realized capital gains as a result.

Three of the 10 ETFs in Exhibit 2 fit the maturity-bracketed bond ETF mold described above. These three funds focus on the far end of the yield curve, where the gains stemming from falling interest rates were the greatest. All three experienced significant inflows through November, so opportunities to boot appreciated bonds through in-kind redemptions were scarce. This forced their portfolio managers to sell some of these positions as they moved toward maturity and out of their respective benchmarks, and recognize gains in the process.

Big Bond ETFs Exhibit 3 features the 10 largest ETFs as measured by Nov. 30 assets under management that expect to distribute capital gains to shareholders in 2020. All 10 are bond funds, including the ETF share class of the world's largest bond fund, Vanguard Total Bond Market ETF BND. Each was affected to varying degrees by some combination of strong inflows, buoyant bond markets, and/or a singular focus on a particular segment of the yield curve.

ETF Sponsors' Report Cards Exhibit 4 summarizes estimated capital gains distributions among the 12 ETF sponsors included in the sample. The figures say more about the makeup of these firms' ETF lineups than they do about their ability to manage their ETFs' tax efficiency. In general, there is a strong positive correlation between the number of bond ETFs these companies offer and the number of their funds that they expect to distribute gains.

At 23, iShares has the largest number of ETFs expecting to pay out capital gains this year. The majority of those (20 of 23) are bond ETFs. Vanguard has the largest percentage (12%) of its ETF range expecting 2020 capital gains distributions. That said, the firm’s denominator is relatively small, as it has just 81 ETFs in its lineup. All 10 Vanguard ETFs anticipating distributions are bond funds. State Street’s figures are also noteworthy. Just three of its ETFs will pay out gains. The firm has significantly improved the tax profile of its ETF lineup in recent years as its portfolio management team has more explicitly incorporated tax considerations into their process.

The Big Picture Exchange-traded funds aren't impervious to distributing capital gains, but most have avoided them, giving them a leg up over mutual funds in a taxable setting. This owes primarily to their regular use of the in-kind redemption mechanism to rid their portfolios of appreciated securities to meet redemptions. Finally, it is important to remember that capital gains distributions are just one component of the tax equation. Taxable investors will still get a tax bill for any regular income distributions from their funds.

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