Many investors understand that exchange traded funds (ETFs) are tax efficient. This efficiency is primarily due to the fact that few ETFs distribute fund-level realized capital gains to shareholders. However, investors and advisors may find it surprising when one of their ETF holdings suddenly presents them with a distribution of realized capital gains. Let’s take a closer look at why typical ETFs are tax efficient and why, in some scenarios, ETFs may pass on fund-level realized capital gains to investors.
Realized capital gains occur when securities (which have appreciated above their cost basis) are sold for cash. However, ETFs can improve tax efficiency by using in-kind transfers to manage cost basis and to decrease the need to convert holdings to cash. In-kind transfers work by enabling an ETF to swap securities held in its portfolio for ETF shares held by an authorized participant (AP), and vice versa. This transaction is not a taxable event because the ETF does not liquidate any of its holdings. In addition, ETFs can also improve tax efficiency by using in-kind transfers to manage the cost basis of the fund’s underlying holdings (i.e. the fund can transfer low-cost-basis securities out of its portfolio). Overall, the continual use of in-kind transactions throughout a typical ETF’s day to day operations, which include portfolio rebalances (when an ETF buys and sells securities to better track its index) and redemption orders (when ETF shares are removed from circulation), improves tax efficiency.
However, ETFs sometimes do realize and distribute fund-level capital gains to shareholders. International ETFs which invest in restricted markets that do not allow in-kind transfers, and currency-hedged ETFs which use derivatives as part of their strategy are two types of ETFs that are structurally more likely to realize capital gains than other ETFs. On the other hand, ETFs that rarely distribute capital gains may do so in certain circumstances as cash sales in some funds may be unavoidable.
There are a handful of restricted international markets, including Brazil, India, and Malaysia, where local securities regulations do not permit in-kind transactions. As a result, ETFs that operate in these markets must sell securities and use the cash proceeds to meet redemption orders or to execute rebalancing trades. For redemption orders, the ETF delivers the cash it raises (instead of securities) to an authorized participant in exchange for ETF shares. These actions may cause ETFs that operate in restricted international markets to accrue fund-level realized capital gains, which are distributed to shareholders before the end of each calendar year.
In addition to these uncommon cases where ETFs aren’t able to use in-kind transfers, there are also ETFs which generate realized capital gains directly through the strategies that they pursue. For instance, currency-hedged international ETFs buy and sell derivatives contracts to hedge fluctuations in exchange rates. The constant purchase and sale of these contracts may generate fund-level realized capital gains that get passed on to investors. In the case of a currency-hedged ETF, a realized capital gain usually indicates that hedging improved fund performance–the U.S. dollar strengthened and investors benefited from the currency hedge.
Overall, ETFs are extremely efficient when it comes to minimizing fund-level realized capital gains, largely due to their ability to transfer securities in-kind. However, investors should understand that ETFs which access restricted foreign markets or use derivatives might realize capital gains. We hope that by digging deeper into ETF mechanics, this blog gives investors a better understanding of one of the key benefits of ETF investing, namely tax efficiency due to minimal distributions of fund-level realized capital gains.
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Any tax information contained within this blog is merely a summary of our understanding and interpretation of some of the current tax laws and regulations and is not exhaustive. Consult your legal or tax counsel for advice and information concerning your particular situation. Neither Deutsche Asset Management nor any of its representatives may give tax or legal advice.