ETF Tax Benefits Continued In 2020
Key Takeaways
An estimated 94% of equity and fixed income ETFs offered by iShares, State Street Global Advisors and Vanguard that are also star rated by CFRA will pass along zero capital gains to existing shareholders in 2020.
The iShares Core MSCI EAFE (IEFA), SPDR S&P 500 ETF Trust (SPY) and Vanguard Total Stock Market ETF (VTI) are among the 99% of equity ETFs unlikely to incur a gain.
While a slight tax burden was more common with fixed income ETFs in 2020, iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK) were not on the list.
Most of the investors who plowed $290 billion into ETFs from the top three providers in 2020 will not receive unexpected capital gains. In mid-November, BlackRock, State Street Global Advisors and Vanguard released initial estimates of which ETFs they anticipate passing along capital gains to existing shareholders at year end.
Combined, these firms manage 81% of the more than $5 trillion of assets for U.S.-listed products according to CFRA’s First Bridge ETF data. While a lot of the money is in relatively passive market-cap-weighted index-based funds, these firms also offer smart-beta ETFs that are rebalanced during the year as well as a small number of actively managed ETFs.
CFRA rates 569 equity and fixed income ETFs from these firms, based on a combination of holdings-level analysis and fund attributes. We cover funds relatively early into their trading history and do not have a minimum asset base threshold. Based on the Big 3 asset manager estimates, 94% of these funds are not expected to incur any capital gain.
Figure 1: % of Equity and Fixed Income ETFs Expected to Not Pass Along Capital Gains in 2020
Source: BlackRock, State Street Global Advisors and Vanguard estimates. Percentages based on CFRA’s ratings as of November 17, 2020
Equity ETFs
Taxes are not an issue for loyal equity ETF investors. Just three equity ETFs offered by the top-tier asset managers, equal to less than 1% of the 416 funds rated by CFRA, are expected to incur a capital gain this year. All three are offered by BlackRock with the largest capital gain, as a percentage of its net asset value (NAV), coming from the $26 million iShares Evolved U.S. Innovative Healthcare ETF (IEIH).
This actively managed sector fund is expected to pay out capital gains between $0.53 and $0.65 a share, equal to a range of 1.7% and 2.1% of its NAV. The firm’s two other capital gains-generating ETFs are projected to see negligible gains equal to less than 0.12% of their NAVs.
More importantly, the popular market-cap-weighted IEFA and smart-beta iShares Edge MSCI Min Vol USA ETF (USMV) are among the equity ETFs not included on this list of cap gains payers.
Also, both State Street Global Advisors and Vanguard do not expect to pass any capital gains on to shareholders of their equity ETFs. The firms’ lineups include market-cap-weighted SPY and VTI as well as smart-beta offerings such as the SPDR MSCI USA StrategicFactors ETF (QUS) and the Vanguard Dividend Appreciation ETF (VIG).
Investors in these and other equity ETFs do face tax consequences when they sell their shares. But unlike with a mutual fund, redemptions by other shareholders do not typically create a taxable event for long-term holders of the ETF.
Fixed Income ETFs
Modest capital gains are more common in 2020 with fixed income ETFs. Using CFRA’s rated ETF universe, 78% of fixed income funds from the Big 3 ETF providers were not expected to pass along a capital gain to shareholders. State Street Global Advisors had the highest percentage that was not expected to incur capital gains at 91%: Just 3 of the 33 fixed SSGA fixed income products covered by CFRA were expected to incur a gain.
One of the funds, the $3.3 billion SPDR Nuveen Bloomberg Barclays Municipal Bond ETF (TFI), was projected to pass along a modest total gain equal to 0.10%-0.23% of its NAV. Meanwhile, the diverse list of ETFs that are not expected to pass along any gain to shareholders included JNK.
For BlackRock, 80% of its fixed income ETFs covered by CFRA should not incur a gain, including popular LQD. According to BlackRock, most of the remaining funds are expecting to pay out less than 1.0% of their NAV. One rare exception is the $1.0 billion iShares Convertible Bond ETF (ICVT), where shareholders should expect a gain between 3.0% and 3.6% of NAV.
Lastly, Vanguard has the fewest fixed income ETFs rated by CFRA, yet 10 of the 19 are expected to incur a capital gain. All but two of them are estimated to be less than 1.0% of NAV, with the $1.7 billion Vanguard Extended Duration Treasury ETF (EDV) likely to be the highest at 3.2% of NAV. In contrast, the $35 billion Vanguard Short-Term Corporate Bond ETF (VCSH) is among the ETFs not expected to incur a gain.
Better Tax Efficiency
ETFs are generally more tax efficient than mutual funds. Unlike mutual funds, ETFs generally do not sell securities when investors redeem their shares. Most trading takes place in the secondary market, with sell orders being crossed with buy orders through the exchange as they are with stocks. When the selling pressure exceeds the demand, ETF shares are redeemed through an authorized participant using an in-kind mechanism that allows the fund to reduce the likelihood of capital gains.
In addition, index-based equity ETFs typically have lower turnover rates—SPY has an annual turnover rate of just 3%—than active mutual funds, where the management team has discretion to take profits throughout the year. With less trading at the fund level, fewer capital gains are incurred with equity ETFs.
With fixed income ETFs, turnover tends to be higher as bonds mature within the year and the funds often have cash-based redemptions. As such, the percentage of ETFs incurring slight capital gains is more common.
For example, in the mutual fund space, T Rowe Price has 10 mutual funds with an estimated capital gains distribution higher than 10% of NAV and Fidelity Investments has five. This list of funds with unwelcome shareholder gifts includes the Fidelity Select Technology (FSPTX) and the T Rowe Price New America Growth (PRWAX), which are expected by these asset management firms to pay out capital gains equal to 16% and 14% of their respective NAVs. Both firms also launched their first nontransparent actively managed equity ETFs in 2020.
Conclusion
One of the benefits investors in ETFs have historically enjoyed is strong tax efficiency. Based on the initial forecasts from the top three asset managers, 2020 has continued that trend. We think ETF-focused advisors and investors will have fewer surprises at year end, and we expect those investors who mix ETFs and mutual funds together will be more inclined to shift toward strategies that incur fewer taxable events in 2021.
All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. For more information and disclosures, please refer to CFRA's Legal Notice at https://www.cfraresearch.com/legal/.
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