Expect Another Year Of Limited Capital Gains Taxes For ETFs

This is the time of year when advisors and investors start talking about the tax implications facing portfolios, and that includes portfolios comprised of exchange-traded funds.

Due to the fact that most ETFs are passively managed, capital gains distributions in this asset class are usually rare.

ETFs And Tax Implications

Distributions are paid to investors from the capital gains of the firm's investment portfolio. For example, when a mutual fund manager turns a profit on a trade and closes the position, the fund's shareholders, not the sponsor, are saddled with the tax liability. Most ETFs do not distribute capital gains to investors, which makes the asset class typically more tax efficient than mutual funds.

Moreover, ETFs are also generally more tax efficient than mutual funds because of how new ETF shares are created and redeemed. When an individual investor wants to sell an ETF, he simply sells it to another investor similar to a stock on an exchange. An authorized participant (AP) or broker dealer redeems shares of an ETF when there are more sellers than buyers.

But rather than iShares or Vanguard selling stocks to pay the AP in cash as occurs with a mutual fund the asset manager simply pays the AP in kind by delivering the underlying holdings of the ETF itself. The asset manager can pick and choose which shares to give the AP those shares with the lowest possible tax basis. By not selling any shares, there is no capital gain incurred, said S&P Capital IQ in a note out Tuesday.

Tax Advantages

Limited portfolio turnover is a primary reason why passively managed ETFs have significant tax advantages of their actively managed mutual fund rivals.

As S&P Capital IQ noted, portfolio turnover for the popular Vanguard 500 Index Fund (NYSE:VOO) is expected to be just 3 percent this year. That is a far cry from the Lipper large-cap core mutual fund average of 70 percent.

Another Example

Even the $8.5 billion iShares S&P 500 Value Index (ETF) (NYSE:IVE) is expected to have limited portfolio turnover this year. As a strategic beta ETF, IVE's turnover in a given year is likely to be higher than a fund such as VOO, because more stocks will move in and out of IVE when the ETF rebalances to meet certain investment criteria. However, IVE's turnover is well below that of an equivalent actively managed mutual fund.

Even IVE that is rebalanced annually based on book value, P/E and other traits of the broader index's constituents, has a turnover rate of just 25 percent, well below the 52 percent Lipper large-cap value mutual fund peer average. Neither VOO nor IVE expects to incur a capital gain this year, said S&P Capital IQ.

The research firm has Overweight ratings on both IVE and VOO.

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