Trending
One of the primary reasons behind advisors’ and investors’ affinity for exchange traded funds is tax efficiency and much of that is born out of lack of capital gains distributions.
Put simply, capital gains distributions aren’t desirable because they are taxable events with the investor, not the fund company, responsible for the bill. The rarity of these events in the ETF world makes the ETF structure inherently more tax efficient than what’s found among actively managed funds.
“A capital gains distribution is a payment by a mutual fund or an exchange-traded fund (ETF) of a portion of the proceeds from the fund's sales of stocks and other assets from within its portfolio. It is the investor's pro-rata share of the proceeds from the fund's transactions,” according to Investopedia. “It is not, however, a share of the fund's overall profit. The fund may gain or lose money over the course of a year, and your balance will rise or fall accordingly. But if the fund gained from the sale of any of its stocks during that year, it will make capital gains distributions to its shareholders.”
This year marks yet another in which the capital gains advantages offered by ETFs were clearly evident. Read on for more details.
ETFs Keep Winning Capital Gains Battle
In the more than three decades since the first ETF debuted in the U.S., these funds have been consistently better than active mutual funds regarding annual capital gains distributions and to a large extent. That trend remained in place this year.
“Exchange-traded funds’ tax advantage shone through once again in 2024. Less than 4% of the ETFs we surveyed are projected to distribute capital gains this year. Of those, most are projected to pay out less than 1% of the fund’s net asset value,” notes Morningstar analyst Brendan McCann.
The research firm analyzed cap gains activity among more than 1,800 domestically traded ETFs from 15 issuers and while that’s not the entire U.S. ETF industry, it still provides advisors and investors with a clear sense of the capital gains efficiencies offered by the ETGF structure.
It’s also worth considering why some of the ETFs in terms of the top 10 capital gains distributions make that dubious list. Some are leveraged ETFs, which use swaps and derivatives, which can shorten the odds of cap gains being lobbed off. Others are international funds tracking markets where in-kind transactions aren’t allowed.
“Many countries, especially emerging markets, don’t allow in-kind transactions. India is one of those countries, and three ETFs tracking that market made the top 10 for distributions as a percentage of NAV,” adds McCann.
Some of the other “offenders” were sector ETFs with unique strategies and exposure to stocks from countries that don’t allow in-kind transactions.
Big Names Score Well
The largest ETF issuers had another impressive year in terms of limiting capital gains. Of the top 15 based on assets under management, 11 had less than five funds that subjected investors to capital gains. Charles Schwab and Goldman Sachs didn’t have any.
That speaks to the benefits of the creation and redemption process used by ETFs – one in which institutional investors ad market makers known as authorized participants create and redeem ETF shares. Mutual funds don’t use that process.
“APs deliver a basket of securities to the ETF issuer in exchange for new ETF shares, which they then sell to investors,” concludes McCann. “When an investor sells their shares, the AP buys them and exchanges them for the basket of securities from the ETF issuer. This exchange, known as an in-kind transaction, allows ETFs to avoid capital gains since the ETF provider doesn’t transact in cash.”