ETF tax advantages

The three key characteristics that make exchange–traded funds (ETFs) tax-efficient are easily defined. They are:

Index-based ETFs have extremely low turnover. Transactions trigger gains taxable in the hands of unit holders.

The redemption of ETFs allows for in-kind transfers, allowing sponsors to transfer out the lowest cost shares without incurring tax. This maintains the adjusted-cost base closer to the market value. Unit holders pay most taxes when they sell the ETF, effectively deferring taxes until realized.

The creation method and exchange-traded nature of ETFs means supply and demand are balanced in the marketplace and units do not have to be sold (incurring a possible tax liability) to meet redemption requirements as mutual funds do. As a consequence, ETFs hold less cash to earn taxable income (albeit not much lately given low interest rates).

These tax-minimizing characteristics are a big relief for taxable investors. Had they owned mutual funds, they could be subjected to big taxes unrelated to their actual investment results. Paying for the capital gains or income received by others is just silly.

Tax losses

ETFs are ideally suited for capturing tax losses. The conventional way is to replace a losing stock position with an ETF. Example: sell Research in Motion (RIM) at a loss to buy iShares Canadian Tech Sector ETF (XIT). The loss in the stock position is captured to be used to offset capital gains in the current year, back three years or carried forward indefinitely. The portfolio exposure, to the technology sector in this case, is maintained.

Another effective tactic is to swap between ETFs with similar underlying risk. An example is iShares S&P 500(IVV) and SPDR 500(SPY). Both have the S&P 500 as their underlying index but because the ETFs have different sponsors, BlackRock and State Street Global Advisors respectively, they are considered different securities for tax purposes. Therefore, they may be traded simultaneously to capture a loss. The 30-day waiting period to avoid a superficial loss is not required.

Holding a core portfolio of ETFs and owning a satellite portfolio of individual stocks is a good way to protect capital gains generated by the stock portfolio by applying tax losses generated from the core. Some firms may offer a tax-loss-capture module, like PŮR Investing, that does this automatically.

Caution

Ioulia Tretiakova, director of quantitative strategies for PŮR Investing, says while ETFs have tax-efficient characteristics, some have shocked investors at tax time. The 2008 experience with some leveraged Rydex Inverse sector series ETFs is shown below.

Tretiakova explains that inverse, leveraged long and leveraged inverse ETFs use swaps and derivative instruments rather than securities that can be transferred in kind. This creates potential tax liability when the contracts are closed out. Capital gains, influenced by volatility and the expiration of futures contracts related to the underlying sectors on January 1, 2009, were huge for several Rydex ETFs. In Canada, a similar situation is not expected although in 2012 the Horizons Beta Pro’s leveraged ETF products listed below have OTC derivative contracts maturing. A different Canadian structure, unavailable in the U.S., allows sponsors to better minimize taxes. At any rate, leveraged ETFs should always be watched carefully.

Screening ETFs for tax efficiency

While it should be clear by now that taxable investors should always use ETFs rather than mutual funds, differences in the tax efficiency of ETFs bears some attention. Like other forms of investing, “tax” should never be the prime reason to make an investment, however, it is common sense to be mindful of an instrument’s tax impact.

Screening ETFs by the proportional size of their historical distributions is a fair way to assess their tax efficiency. It is these distributions that incur the tax that investors seek to avoid. To be fair, indexes that change their components or are in start-up mode, may incur more transactions and more taxable activity. This should diminish over time. When choosing between similar ETFs, picking the one with better tax efficiency may improve your after-tax return. To see the tax efficiency of ETFs trading in Canada, check the free screener at: http://purinvesting.com/demo/Screen.htm

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.