With so much talk about tax policy and possible alterations to the U.S. tax code, advisors have an opportunity to remind clients about the tax efficiencies of exchange traded funds.
While in the U.S., ETFs are an asset class closing in on three decades of existence, many investors still aren’t aware of the tax benefits offered by this fund structure. That’s where advisors come in, and there’s plenty of support for the conversation.
“As of early December 2021, 15 of the biggest ETF sponsors had reported their estimated capital gains distributions for 2021. These firms back a combined 1,582 funds, which together held more than $6.6 trillion in assets as of the end of November. Among those funds, just 148 (9.4%) are expected to distribute capital gains to investors in 2021,” says Morningstar analyst Lan Anh Tran.
That percentage is above the 5–7% seen in a typical year, perhaps owing to more actively managed ETFs coming to market, but the good news for investors is that a barely noticeable percentage of ETFs distributing capital gains this year will do so to the tune of more than 1% of their end of November assets.
Many of ETFs’ tax benefits stem from the creation/redemption process. To create ETF shares, an authorized participant buys shares of underlying securities and exchanges those units for large blocks of ETF shares with equal value. That’s what’s known as an “in-kind” transaction.
“It is an ‘in-kind’ transaction because the AP is exchanging the same exact securities with the same value; rather than exchanging for cash,” according to WisdomTree.
Unlike with mutual funds, redemption of ETF shares, in most cases, isn’t a taxable event because an ETF issuer doesn’t always have to sell shares when investors want to sell their stakes in the fund.
Of the 10 largest ETF capital gains distributions this year, just one comes from an unleveraged domestic equity ETF. Seven of the funds on that list are fixed income or international equity products.
As for WisdomTree, just five of its ETFs distributed both short-term and long-term capital gains this year, but just one exceeded a distribution of 1% of net asset value. That’s impressive when considering that the issuer has one of the most expansive lineups among all issuers and one that spans multiple asset classes.
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