ETF Winners And Losers From The Great Tax Compromise

by on December 23, 2010 | ETFs Mentioned:

Though the recent tax agreement between the Obama administration and Congressional Republicans was hailed as an historic compromise, there is no shortage of politicians and organizations–from both the left and the right–expressing frustrations with the accord. In addition to extending the Bush-era tax cuts for an additional two years, the deal signed into law last week introduces a 2% payroll tax cut for one year and prolongs the 99-week extended-unemployment benefits for another year.

In promoting the tax cut plan to Congress, Obama presented the deal as a measure that would stimulate spending while at the same time extending unemployment benefits for those hit hardest by the recent downturn. While the plan received bipartisan support in Congress, critics from both the left and the right were quick to blast the compromise. Liberals ripped the extension as a bailout for wealthy Americans, while some fiscal conservatives lamented that the tax cut extensions would be funded by additional borrowing. Now that the dust has settled and the bill has been signed into law, some clear winners and losers have emerged from the latest round of the back-and-forth tax policy debate. Below, we profile some of the ETFs that received the most significant boost from the final outcome as well as some that were adversely impacted [for more ETF insights, sign up for our free ETF newsletter]:

Winners: Dividends, Telecom…Emerging Markets?

When the Bush tax cuts were implemented in May 2003, a major component of the plan was a reduction in the tax rates on dividends and capital gains from almost 40% to just 15%. Had the cuts expired at the end of 2010, the effective tax rate on dividends would have more than doubled, so it’s no surprise that many dividend-paying companies waged aggressive lobbying campaigns to extend the cuts.

It’s also no surprise that utilities and telecom ETFs were among the biggest winners of the tax deal. Part of the appeal of these sectors is the hefty dividend yields they traditionally offer; the Utilities SPDR (XLU) has a distribution yield north of 4%, while the iShares Telecom Index Fund (IYT) offers exposure to some of the U.S. stocks with the highest yield [see Beyond XLU: Three Utility ETFs Worth A Look].

The extension of favorable rates for dividends was also a positive development for dividend-weighted ETFs, funds linked to indexes that determine component securities and weightings based not on market capitalization, but on cash dividends paid. WisdomTree offers a number of dividend-weighted ETFs, including a broad-based domestic equity ETF (DTD), global equity ETF (DEW), and emerging markets ETF (DEM).

Other asset classes that may benefit from the tax policy extension include precious metals and international equities. While the connection between the extension of the Bush tax cuts and these asset classes might not seem obvious, it’s relatively simple to make a bullish argument for gold and silver in the wake of the great compromise of 2010. Prolonging tax cuts will add to an already massive federal deficit, as the additional shortfalls created as a result of this policy will be financed with new borrowings. As Washington’s debt balance increases, so does downward pressure on the greenback and the appeal of alternative hard currencies. All of the funds in the Precious Metals ETFdb Category have surged in 2010, and could continue to rally next year as the costs of the tax extensions mount.

Many of the provisions of the tax deal are short-term in nature, setting the stage for a series of intense battles over the next several years–especially during the 2012 elections. U.S. tax policy has become a collection of short-term fixes and patches, creating greater uncertainty for business owners about future liabilities. “In the late 1990s, there were typically fewer than a dozen tax provisions that had just a limited lease on life and needed to be renewed every year or so,” writes John McKinnon. “Today there are 141.” While the recent changes to tax policy haven’t necessarily made the U.S. an undesirable place to do business, the lack of a cohesive tax policy has created a level of uncertainty that may discourage investment and hiring. For companies looking to expand operations, the U.S. is looking less and less appealing thanks to the tax uncertainty that could be a mainstay for the next several years, if not longer [see Emerging Markets ETF Center].

MLP ETNs Get A Boost

Another less obvious beneficiary of the tax cut extensions are certain exchange-traded products that offer exposure to the MLP sector, a corner of the domestic energy market that has become a popular choice for investors looking for attractive yields. There are now both ETFs and ETNs that offer exposure to indexes comprised of MLPs, and there has been a fair amount of confusion over the potential benefits and drawbacks of each structure [see MLP Exposure: ETF or ETN?]. Distributions from MLP ETNs are taxed at individual income tax rates, so the extension of the 35% maximum is good news for anyone with holdings in MLPI or any of the other MLP ETNs [see Do You Need A MLP ETN?]

Losers: Munis, Treasuries, Dollar

With each passing day, it seems as if the Build America Bond program will not be as fortunate as the Bush tax cuts, and will expire at the end of 2010. The program, launched as a part of the American Recovery and Reinvestment Act of 2010, had provided state and local governments with subsidized access to taxable debt markets, allowing them to raise capital to fund projects at financing rates lower than they would have otherwise been able to achieve. While debt issued by these municipalities was taxable–traditional muni bonds are tax-exempt–the Treasury paid 35% of the interest costs, thereby allowing issuers to offer juicy yields to investors without having to pick up the entire bill on the interest costs [see the Wide World Of Muni Bond ETFs].

The expiration of the Build America Bond program isn’t necessarily bad news for the ETFs that offer exposure to this asset class; existing securities will continue to be subsidized by the federal government, and because many of these bonds don’t mature for at least 20 years, BABs will be around for the foreseeable future. The real pain was felt by municipal bond markets, as investors expect a surge in activity in tax-exempt markets next year. Without the option of issuing BABs, traditional muni bond markets could get crowded next year, forcing issuers to offer more attractive interest rates if they hope to secure financing. More attractive yields in the future diminishes the appeal of outstanding securities, which has sent muni bonds plummeting in recent weeks (lingering concerns about the ability of municipalities to make good on the obligations have also played a roll in the collapse).

Also taking a hit were Treasuries, as the increased likelihood of additional borrowing in the near future is obviously a negative development for outstanding debt. Moody’s initially said that the tax extension would “adversely affect” the budget deficit, raising the chance of a negative outlook for the Aaa credit rating. “From a credit perspective, the negative effects on government finance are likely to outweigh the positive effects of higher economic growth,” wrote senior credit officer Steven Hess. A loss of the coveted Aaa rating certainly isn’t imminent, but the increasing debt burden has put pressure on all ETFs in the Government Bonds ETFdb Category.

The bigger debt load could also be bad news for the dollar, which has endured an up-and-down year to date. Investors looking to bet against the greenback have a couple of different ETF options; WisdomTree’s CEW offers exposure to emerging market currencies, while UDN offers short exposure to the dollar relative to a basket of developed market currencies.

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Disclosure: No positions at time of writing.