ETF Tax Efficiency isn’t Always Efficient

WHEREAS, Wes Gray hires you to join the team at ETF Architect; and

WHEREAS, you have industry experience from OUTSIDE of Alpha/ETF Architect; 

NOW, THEREFORE, BE IT RESOLVED, that you should write a blog post (warning – prospective future employee!)

Drawing the short straw, Wes asked that I put together a piece that throws some cold water on ETF tax efficiency. Why? Well, there are already plenty of situations where ETFs are incredibly tax-efficient, but we want to provide a fuller picture.⁽¹⁾.

To frame this discussion properly, we must first state that ETF’s are incredibly tax-efficient vehicles in many situations. By using the redemption-in-kind mechanism for transacting securities with Authorized Participants, ETFs can avoid distributing a vast majority of capital gains received by the fund. When shareholders receive capital gains distributions, they need to pay taxes on the amount received. The compounding effect of keeping this money in the fund (and out of the IRS’s bank account) can provide long-term benefits for ETF shareholders.

Compared to mutual funds or separately managed accounts, ANY benefit from redeeming in-kind⁽²⁾ is a bonus. That being said, not all ETFs and situations are created equal when it comes to tax efficiency, and the “golden rule” always applies – when given the option, the IRS wants to create scenarios where they receive tax dollars now instead of later. Here are some big-ticket items that cause inefficiencies (read as taxes…), many related to the “golden rule” above.

In-Kind vs In-Cash Redemptions

Inefficiency tour stop #1 – if your ETF can’t transact in-kind, it must distribute gains received from selling securities. There are many reasons why this may be the case:

1. The markets do not support in-kind transactions. Most U.S. and developed market securities are good candidates for transacting in-kind. On the other hand, many emerging markets – Brazil and India for example – require settlement in-cash (the advisor must sell the security on the open market, triggering a taxable event, and deliver the proceeds from the sale instead of the security itself). When these in-cash settlements create gains, they are taxable and require additional taxable losses (see tax loss harvesting below) to offset them for the fund to avoid distributing capital gains. An ETF may consider holding an ADR/GDR of the security if it allows for in-kind transactions, but there are trade-offs for going this route.
   


2. Economics (ETF Size). Bringing in money and growing assets solves many problems in the advisory world. The same is true for avoiding capital gains distributions by ETFs. Funds with lower assets end up paying a larger fee as a percentage of assets for any custom basket (specific sub-set of the funds holdings) it wishes to redeem in-kind. Additionally, trading costs of turning over a portion of the portfolio may end up being the greater of two evils. Just because an ETF has lower asset levels does not guarantee cap gains distributions, but it does limit the advisors arsenal and create complex questions of what is in the best interest of shareholders.
   


3. A few more in-cash scenarios in rapid fire. Our team at ETF Architect would love to elaborate – come find us here!)
   1. Illiquid securities
   2. Derivatives
   3. Odd lots
   4. AP relationships

30-Day Wash Sales

This policy is one of the IRS’s best friends for thwarting efforts at tax-loss harvesting. For starters, the process of tax-loss harvesting involves a fund with realized gains intentionally selling securities in a depreciated state (the current price is less than the cost initially paid) in order to “harvest” (realize) those losses and offset the realized gains/reduce the distribution requirement. As you can imagine, the IRS isn’t a huge fan (remember the “golden rule!”) and therefore requires a fund to “wash out” any losses received from selling a security purchased within 30 days before OR after the sale. A fund can avoid wash sales with in-kind baskets, forward planning, and timely tweaks to its basket of securities, but make no mistake, this dance falls under the category of “art” instead of “science.”

Pass-Through Capital Gains

Moving from broad to niche situations, a fund must consider the tax character of distributions received from its underlying securities. ETFs investing in other funds (Fund-of-Funds), REITs (Real Estate Investment Trusts), and Closed-End Funds often receive cap gains distributions from these underlying investments that the fund must distribute to its shareholders. These securities commonly “reclass” their distributions AFTER they are paid, forcing the ETF to react to a change in character at a later date. 

Conclusion

In summary, while ETFs are generically labeled as “tax-efficient,” that term is not all-inclusive. As a U.S. equity-only ETF investor, your expectations of avoiding capital gains distributions are reasonable, but not foolproof. Oftentimes, the advisor must choose between tax planning efforts and their belief of what is best for the shareholder. This can include holding a security vs. selling to harvest losses, holding substitute securities, and many others. When an advisor must choose between paying out capital gains (with the unfortunate optics included) or deviating from the fund’s strategy, their fiduciary duty requires doing what is best for the shareholder (even if that results in capital gains distributions and taxes).

These topics aren’t fun (even for CPA nerds like me), but are an important facet of ETF servicing and for buyers of ETFs. The more knowledge a fund sponsor has of potential pitfalls, the easier they are to proactively address. The goal is to thread the needle of tax efficiency while still maintaining integrity to the fund’s strategy. Refreshed by the cold water wash, let us help choreograph the dance that is ETF operations.