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Another Stellar Year For ETF Tax Efficiency

ETF Professor

Among the myriad reasons advisors and investors have gravitated to exchange traded funds over actively managed funds in recent years are superior tax efficiencies.

When active fund managers sell part or all of a position at a profit, investors foot the tax tab via a capital gains distribution, but that phenomenon is rare in the world of ETFs.

What Happened

BlackRock Inc.'s (NYSE: BLK) iShares unit is the world's largest ETF issuer not just in terms of assets, but also in terms of offerings. In the U.S., iShares offers more than 300 ETFs, a scant percentage of which will deliver capital gains distributions in 2018.

“When an investor sells an ETF, his or her trade is typically crossed with another investor, just as it would with a stock that trades on an exchange,” said CFRA Research Director of ETF & Mutual Fund Research Todd Rosenbluth in a Monday note. “Such a transaction could result in a capital gain or loss for the seller, but all other shareholders would not be affected. Even if enough shareholders want to sell, an authorized participant might remove shares from the market by redeeming shares of the ETF to the asset manager.”

More than 96 percent of the iShares lineup will not pay capital gains this year, according to Rosenbluth. Several of the 14 iShares ETFs that will make capital gains distributions are currency hedged funds, such as the iShares Currency Hedged MSCI EAFE ETF (CBOE: HEFA). Currency hedged ETFs use futures contracts to hedge currency risk, which can create capital gains when those contracts are sold at a profit.

Why It's Important

Vanguard is the second-largest U.S. ETF issuer by assets, though its lineup is considerably smaller than iShares' at about 80 funds. Pennsylvania-based Vanguard said some of its mutual funds will make captial gains distributions, but none of its ETFs will, according to Rosenbluth.

Popular Vanguard ETFs include the Vanguard Total Stock Market ETF (NYSE: VTI) and the Vangaurd S&P 500 ETF (NYSE: VOO). VOO and VTI are two of the top six ETFs in terms of new assets added this year.

What's Next

State Street Global Advisors, the third-largest U.S. ETF sponsors, also has an impressive 2018 when it comes to capital gains. Just seven of the firm's approximately 140 ETFs will pass capital gains distributions onto investors this year, according to Rosenbluth.

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