Did you have any caffeine today? Have you had any form of exercise this week? For most people, this is just routine and not worthy of discussion. I find for many the same is true with ETFs and capital gains. However, the ETF pie continues to expand with newer investors each year. The persistent lack of a capital tax gain burden simply for holding onto an investment is worthy of celebration.
BlackRock announced that just five of its 427 (1.1%) U.S.-listed ETFs will pass along any capital gain. Meanwhile none of the 138 ETFs offered by State Street Global Advisors nor any of the 82 ETFs offered by Vanguard is expected to share a tax burden. That’s more than 600 ETFs that will have no hidden surprises for its end investors. No wonder so many advisors are shifting to ETFs.
Capital Gains Is Common for Equity Mutual Funds, Rare for ETFs
Those that grew up with mutual funds as the primary vehicle to access stock and bond markets likely have received an annual capital gains or loss even when they did not make any changes to their portfolio. As other mutual fund investors sell shares, fund managers often need to rebalance the fund. In addition, managers may sell stocks that meet objectives or no longer look attractively valued. Such changes can create taxable liabilities for the remaining shareholders.
According to Morningstar data, 81% of U.S. active equity mutual funds paid out taxable capital gains over the past five years. We have already seen some 2023 capital gain announcements for well-known funds like American Funds Growth Fund of America and MFS Value Fund.
In contrast, ETFs trade on an exchange where sellers typically transfer shares to another investor. As a result, ETF companies do not need to sell shares of underlying investments to meet redemptions. When they do, ETFs make in-kind redemptions through authorized participants using low-cost basis securities rather than cash. Such actions limit the likelihood of realizing capital gains.
Strong-Performing ETFs Rewarding Loyal Shareholders
As mentioned, State Street Global Advisors is not expecting capital gains for any of its ETFs. The firm’s lineup includes some strong performing sector funds such as the (XLC ) and the (XLK ). XLC and XLK were up 36% and 33%, respectively, year to date as of October. In addition, the (EDIV ) gained 25%. Meanwhile, the firm offers the largest ETF in the world. The+ SPDR S&P 500 ETF+ (SPY ), which manages more than $400 billion in assets, was up 10%.
Vanguard similarly is not expecting any capital gains. The (MGK ), which manages $15 billion in assets, rose 31% in the first 10 months of 2023. The ETF owns many of the top-performing large-cap stocks but will not be passing on any capital gains. Neither will the (VUG ), a $94 billion fund that climbed 26% year to date through October.
We are highlighting equity ETFs since capital gains are likely to be expected in an up year. However, Vanguard is not expecting any capital gains to be incurred for fixed income ETFs either. That’s true even for a fund like the (VGSH ), which was up 2% for the year.
BlackRock’s Largest ETFs Have No Tax Bill Either
Meanwhile, the (IVV ) was one of 422 BlackRock ETFs trading in the U.S. that is not expected to not pay out a capital gain or loss. The $355 billion has a lower expense ratio than SPY. Other widely held iShares ETFs forecasted by the company to not have a taxable event include the (IEFA ) and the (IWM ). IEFA and IWM manage $96 billion and $50 billion, respectively.
We expect most loyal shareholders of iShares ETFs will not receive a tax burden. The largest of the ETFs expected to pay a gain is the (EWT ). The firm manages $3.1 billion in assets. Meanwhile two others, the (IWTR ) and the (ETEC ), combined manage $9 million in assets.
ETFs continue to gain market share from mutual funds. Advisors and end clients are increasingly seeing many benefits, including a more tax-efficient approach to investing. We think the continued lack of capital gains being passed on will further drive demand. The absence of bad news is worthy of greater celebration.
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