Surprise! Here’s Your ETF Capital Gain Distribution!!

One of the selling points of exchange-traded funds (ETFs) is they are tax efficient because they funds themselves almost don’t generate any capital gain distribution, which can be taxed at a rate as high as 35%, comparing to their mutual fund counterparts. ETF capital gains are usually realized when investors sell the fund at profit.

This perception, however, is quietly changing to investors disadvantage.

Yesterday, an article in The Wall Street Journal revealed, based on data compiled by Morningstar, that in 2007, 95 out of a total of 613 ETFs made capital gain distributions, with 47 funds giving investors 1% or more of the assets.

As ETFs gaining popularity among investors because of the advantages they hold over mutual funds, such low cost, flexible pricing and trading, and tax benefits, new ETF products have been rolled out almost on a daily basis in the past year. According to a USAToday story early this month, the total number of ETFs in 2007 is 613, up from 359 in 2006. While the newly launched ETFs give investors exposures to sectors that were not covered by ETFs before, many of those new comers sliced and diced the market so thin that they offer investors little diversification as the fund only hold a handful of securities. And most of them failed to get much of investors’ attention as well. Of the 672 domestic equity and bond ETFs currently listed on Morningstar.com, only 219 have a daily trading volume larger than 10,000 shares and 331 ETFs have fewer than 1,000 share changing hand every day. Not only the lack of trading volume makes those ETFs expensive to own (the larger bid/ask spread), but also cost investors as they intended to incur capital gains, noted in the WSJ article:

Newer funds — those launched in 2006 or 2007, after the ETF business began to explode in size — were three times more likely to pass along capital gains than older funds, data from Morningstar show.

So it seems that when choosing which ETF to invest, we do have to look beyond the usual criteria such as cost and return (XTF’s ETF tool provides bid/ask ratio information)

Did you receive any ETF capital gain distribution last year.

Note: Why is ETF tax efficient? According to an article on Yahoo Finance:

Through a regulatory loophole, ETFs are considered to be created by trading equivalent certificates (the ETF for the many stocks that make up the basket) in what is called an in-kind trade. This exchange of essentially identical items does not trigger capital gains, according to the IRS. Traditional mutual funds must go into the open market and exchange cash for stocks and vice versa, which trigger realization of gains. It’s a subtle difference, admittedly, but which results in an advantage for the ETF investor.

*Photo from Craftzine.com

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