ETF Tax Efficiency Report Card

When rattling off the advantages that ETFs hold compared to traditional actively-managed mutual funds, most investors usually start with the issue of expenses. The easiest comparison to make involves expense ratios, the fees charged by ETF and mutual fund companies for investing in a product. Though some mutual funds offer single-digit expense ratios, most actively managed products charge in excess of 1% (the average for the mutual fund industry is in the neighborhood of 1.4%). By comparison, the average expense ratio for ETFs is less than 0.60%, and there are more than a dozen funds that charge less than 10 basis points.

But the potential cost efficiencies of ETFs relative to actively-managed mutual funds go beyond simple expense ratios. ETFs also have the potential to be more tax efficient, thanks to the unique “in-kind” rules of the creation/redemption process. Whereas mutual fund investors may incur capital gains as a result of redemptions by other investors, the fact that ETFs are traded like stocks–on exchanges between market participants–means that they will generally be more tax efficient. That doesn’t mean that ETFs will allow investors to avoid capital gains taxes, rather, they will generally have more control over when these gains are incurred [see Why ETF Really Stands For Efficient Tax Features].

It’s important to note that while ETFs have the potential to offer increased tax efficiency, they aren’t guaranteed to avoid generating capital gains for investors. While the success rate is generally very high, a handful of ETFs will generate capital gains this year, sticking investors with a potentially undesirable tax liability. But for the most part, 2010 was yet another tax efficient year for the ETF industry, with most issuers reporting few capital gains distributions (and a few even reporting perfect results). Below, we highlight the tax efficiency reported for several of the largest ETF issuers this year:

iShares

With more than $400 billion in AUM, iShares is by far the largest player in the U.S. ETF industry (current market share is around 45%). The company wasn’t perfect on capital gains in 2010, but came pretty darn close; only five out of 219 ETFs will pay capital gains distributions this year, all of them bond ETFs. Those funds making distributions will deliver very minor payouts; aside from MBB, the other four funds are making total distributions equal to less than 0.25% of NAV (MBB’s capital gains distributions come in at about 2.3% of NAV):

State Street

State Street, the issuer behind the two largest ETFs by total assets (SPY and GLD) announced that it will be making capital gains distributions for a handful of its ETFs this year:

Vanguard

Vanguard has seen its share of the U.S. ETF market surge this year, thanks in large part to its ultra-competitive expense ratios. In terms of tax efficiency, Vanguard ETFs also did pretty well in 2010; only one equity ETF is scheduled to make a capital gains distribution. Additionally, 12 fixed income ETFs will make capital gains distributions:

PowerShares

PowerShares also came close to perfection on capital gains in 2010, announcing zero long-term distributions on 109 pf 112 equity and fixed income ETFs for 2010 (figures that don’t include the commodity products offered in partnership with Deutsche Bank. The three funds that will pay long-term capital gains are:

PowerShares has also indicated that two additional funds, the S&P 500 BuyWrite Portfolio (PBP) and CEF Income Composite (PCEF) may make capital gains distributions this year.

ProShares

ProShares, the largest provider of leveraged and inverse ETFs, announced last month that none of its 99 equity and fixed income ETFs will pay any 2010 capital gains distributions. “A goal of ProShares is to provide investors with opportunities to manage risk and seek returns while also providing them with tax efficiency,” said Michael L. Sapir, Chairman and CEO of ProShare Advisors LLC. “As a result, we are pleased to announce that we expect no capital gain distributions this year.”

Van Eck

Van Eck, known for a number of products focusing on commodity intensive equities, announced distributions on a handful of funds for 2010:

WisdomTree

New York-based WisdomTree, the only publicly-traded pure play ETF issuer, also aced its capital gains test for 2010; none of the company’s 34 equity ETFs delivered short-term or long-term capital gains during the year. “We are pleased to report zero capital gains distributions across our entire family of equity ETFs,” said President & COO Bruce Lavine in a press release. “When investors focus on the costs and tax treatment of their investments they will find ETFs can offer meaningful advantages over traditional products.”

Direxion

Leveraged ETFs are often less tax efficient than traditional ETFs, but Direxion–which offers a number of 3x and -3x products–did a pretty good job in 2010. Twelve of the company’s products incurred short-term capital gains, and only two of those will make long-term capital gains distributions:

PIMCO

Bond fund giant PIMCO will make capital gains distributions for about half of its fixed income ETFs this year, including two active products and five passive funds:

Schwab

Charles Schwab was perfect for its eight equity ETFs, and declared zero capital gains distributions for its three bond funds as well.

Global X

New York-based Global X will make capital gains distributions on five of its ETFs, including the ultra-popular Colombia ETF:

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Disclosure: No positions at time of writing.