For many Americans, this week is the start of their holiday shopping season. Unfortunately, depending on what mutual funds or ETFs they hold in their portfolio, they might soon receive an unexpected gift: a capital gain that incurs a tax.
Equity and fixed-income mutual funds or exchange-traded funds hold a basket of securities. When the securities appreciate in value, as many have in the 2014 up market, and are sold by the fund manager, they accrue capital gains that are passed along to the shareholder.
Even if an investor did not sell shares in the fund during 2014, when the manager takes profits in a holding or more likely trims it to meet redemptions from other shareholders, the investor shares in the tax burden. Such short- and long-term capital gains are more common for mutual funds than ETFs for a few reasons, including lower turnover and differences in how ETF shares are created, yet not all funds are equal.
Most ETFs seek to track indexes that have very little turnover during the year and thus amass far fewer capital gains than an actively managed mutual fund would. For example, the market-cap-weighted Vanguard 500 Index (VOO) has a turnover rate of 3% that is well below the Lipper large-cap core mutual fund average of 67%. Even the iShares S&P; 500 Value (IVE), which is rebalanced annually based on book value, P/E and other traits of the broader index's constituents, has a turnover rate of just 26%, well below the 59% Lipper large-cap value mutual fund peer average. Neither VOO nor IVE expects to incur a capital gain this year.
However, ETFs are also generally more tax efficient than mutual funds, depending upon how new ETF shares are created and redeemed. When an individual investor wants to sell an ETF, he simply sells it to another investor, similar to how a stock is sold on an exchange. An authorized participant or broker-dealer redeems shares of an ETF when there are more sellers than buyers. But rather than iShares or Vanguard selling stocks to pay the AP in cash — as occurs with a mutual fund — the asset manager simply pays the AP "in kind" by delivering the underlying holdings of the ETF itself. The asset manager can pick and choose which shares to give the AP those shares with the lowest possible tax basis. By not selling any shares, there is no capital gain incurred.
As simple sounding as this is in practice, some ETFs do indeed pay capital gains, while some mutual funds pay minimal or no capital gains.
Many fixed-income indexes are rebalanced monthly, taking into consideration numerous market changes including cash flows from coupon payments, new bond issues and bonds that have been called or paid down early. As such, fixed-income ETFs that try to track an index closely tend to have higher turnover rates than equity ETFs. For example, the Vanguard Intermediate-Term Bond Index Fund (BIV) has a 70% turnover rate. We believe this, combined with the fact that Vanguard's ETF and mutual fund share classes have experienced strong inflows and have been less able to shed less tax efficient securities, contributes to BIV's estimated modest $0.49 capital gain for 2014 (0.58% of its net asset value).
By contrast, Metropolitan West Total Return Bond (MWTRX) is a popular actively managed mutual fund with a similar investment-grade style as BIV. MWTRX's estimated capital gain is $0.03 (0.28% of its net asset value). Meanwhile, iShares Investment Grade Corporate Bond (LQD) is not expected by iShares to pay out any capital gain.
Overall, just 5% of the 299 iShares ETFs are expected to pay a capital gain, while 13% of Vanguard's 67 ETFs are likely to do so, according to the respective companies' data. All of the gains for Vanguard stemmed from fixed-income ETFs, with BIV the largest on a percentage of net asset value.
For iShares, in addition to fixed-income ETFs, some country and currency-hedged ETFs will have a tax bill greater than 5% of the ETF's net asset value. One example is iShares Currency Hedged MSCI Germany (HEWG).
Yet equity ETFs and fixed income mutual funds are not always the more tax efficient choices. Indeed, the Dodge & Cox International Stock Fund (DODFX), a widely held international equity mutual fund, is not expected to pay any capital gain for the second consecutive year. We believe this stems for its 13% turnover rate but also active management's ability to offset any capital gains with capital losses. In contrast, American Funds International Growth & Income (IGAAX) is estimated to pay out capital gains between 4% and 6% of its net asset value.
Meanwhile, within fixed income, the actively managed Goldman Sachs High Yield Fund (GSHAX) expects to incur a relatively high total capital gain of $0.137 (2% of its net asset value).
As with many aspects of mutual fund and ETF analysis, there is no one-size-fits-all approach. The fund's structure and the activities of the asset manager play a meaningful role in its tax efficiency.
While S&P; Capital IQ does not incorporate taxes into its multifactor performance, risk and cost analysis, we believe investors need to understand the investment process and what contributes to its capital gains before making decisions.