The following was authored by Paige Corbin, Capital Markets Associate with WisdomTree.
Exchange-traded funds (ETFs) have many benefits that have caused them to expand in terms of assets and offerings over the past decade. In the United States alone, the ETF industry has grown to over $2.7 trillion in assets.1 Not only are ETFs typically low cost and extremely transparent, a key characteristic and an attractive feature is their tax efficiency.
Let’s start from the beginning. Capital gains taxes can occur in two ways. The first is on an individual level, when one sells an ETF or a mutual fund at a gain in a taxable account. For example, if an investor purchased an ETF for $25 and later sold it for $40, he or she would have to pay capital gains tax. The same exact taxation treatment exists for mutual funds and individual stocks; this cannot be avoided. The second way funds (both mutual funds and ETFs) are taxed is on a fund holdings level, when a holding of a fund is sold for a realized gain. At the end of each year if the fund has netted gains, this amount must be distributed to the fund’s shareholders, who are then required to pay taxes on this distribution. Generally, investors would prefer funds that distribute no or little capital gains to defer any tax payments.
ETFs Are Exchange Listed
So, how exactly are ETFs more tax efficient? There are two key differences to focus on when discussing tax efficiency in terms of fund holdings. The first reason why ETFs are more tax efficient is because they are exchange-traded. Shares of the ETF can be passed back and forth on an exchange, just like an individual stock, without creating turnover in the underlying portfolio. If there is no turnover in the underlying securities, a taxable event cannot occur. In contrast, mutual fund shares are always bought and sold directly to and from the mutual fund company, and they are not exchange listed. Almost all inflows and outflows in a mutual fund result in transactions within the portfolio. This can potentially cause a significant taxable event that affects all of the holders of the mutual fund. ETFs greatly benefit from being exchange-traded, especially when secondary market trading reaches critical mass.
The Creation/Redemption Process
The second reason why ETFs are more tax efficient is because of how they often handle inflows and outflows by creating or redeeming shares “in-kind.” Not all ETFs trade millions of shares a day, so to increase or decrease shares based on demand, ETF shares can be created or redeemed by an authorized participant. What does “in-kind” mean? Simply that in case of a redemption, for example, the issuer delivers the underlying holdings of the ETF to the authorized participant in exchange for the ETF shares. The reverse occurs for a creation. No buying or selling of the underlying securities occurred at the portfolio level. The in-kind transfer is not deemed a taxable event.
However, not all ETFs can be created or redeemed in-kind. There are some ETFs with a more esoteric underlyings, such as emerging markets, that cannot use the in-kind feature. While this does occur, these types of ETFs can still benefit from being exchange-traded. For example, the WisdomTree India Earnings Fund (EPI) trades roughly 3 million shares a day,2 so demand can still be transferred without any activity occurring in the underlyings. Mutual funds do not have this benefit and will always have to sell securities to accommodate shareholder redemptions or to reallocate assets.
While ETFs and mutual funds are both a fund wrapper around a basket of securities and are taxed equally at the individual investor level, the exchange-traded and in-kind nature of the creation and redemption mechanism make ETFs significantly more tax efficient at the fund holdings level. The opportunity for a taxable event can be minimized by these two key characteristics, whereas whenever securities are sold for profit in a mutual fund, a capital gains tax event occurs. The ETF tax efficiency is just one of the many benefits of the ETF structure.
1Source: BlackRock Global ETP Landscape, 2/17. 2Source: Bloomberg, 4/3/17.
Important Risks Related to this Article
Neither WisdomTree Investments, Inc., nor its affiliates, nor Foreside Fund Services, LLC, or its affiliates provide tax or legal advice. All references to tax and/or legal matters or information provided in this material are for illustrative purposes only and should not be considered tax and/or legal advice. Investors seeking tax or legal advice should consult their tax or legal advisor.
Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty; this may be enhanced in emerging and/or frontier markets. The Fund focuses its investments in India, thereby increasing the impact of events and developments associated with the region, which can adversely affect performance. As this Fund has a high concentration in some sectors, the Fund can be adversely affected by changes in those sectors. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs.
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In last quarter’s commentary, we discussed the fallacy of predictions, highlighting the difficult year “experts” experienced in forecasting everything from the Brexit vote to the U.S. presidential election. The conclusion was simply that nobody has a crystal ball. However, the challenges associated with prognostication can actually be taken a step further. In some cases, even when the result of a particular event appears a foregone conclusion, there is still no guarantee as to the end result. Back on February 5th, during Super Bowl LI, the Atlanta Falcons led the New England Patriots 28 – 3 with about six minutes to go in the 3rd quarter. At that exact moment in time, ESPN’s win probability model calculated the Patriots chances of claiming victory at 0.2%! Of course, the Patriots overcame those long odds, winning a game for the ages in epic fashion in overtime. Later in February, during the Oscars, “La La Land” producer Jordan Horowitz actually held a trophy in his hands – unlike the Atlanta Falcons. However, mere seconds later, Mr. Horowitz graciously passed the Oscar statuette to the real winner, “Moonlight” director Barry Jenkins – the result of “Best Picture” award presenter Warren Beatty being given the wrong envelope. The point here is that even if it appears a certain outcome is in the bag, there are still no guarantees.
All of which brings us to the events of the first quarter. Fresh off Donald Trump’s equally surprising presidential election victory, economists and market watchers began trumpeting the prospect of accelerating economic growth. President Trump’s pro-growth agenda – infrastructure spending, tax cuts, deregulation, etc. – would lead to a meaningful uptick in everything from jobs to housing to consumer spending. The stock market seemed to agree, with the S&P 500 surging to record highs and volatility running at record lows. As a matter of fact, the first quarter of 2017 marked one of the least volatile periods for the S&P 500 since 1950. Typically, 1% up or down days in the S&P 500 are fairly common, occurring roughly one out of every four trading days. However, from January 1st through March 20th, there were zero such days – and that streak actually extended back to October:
Volatility stems from uncertainty and, at this point, the logical conclusion is there does not appear to be as much uncertainty over Trump’s ability to govern as previously anticipated. As a side note, one of the most prevalent predictions heading into 2017 was that market volatility would spike – this after predictions of economic Armageddon if Trump was elected to begin with. Score another one against prognosticators.
In addition to optimistic economists and a levitating stock market, confidence has surged among consumers and businesses in anticipation of potential economic growth. Many key measures of consumer and business confidence are at multi-decade highs, which makes sense given the characteristic economic positives of infrastructure spending, tax cuts and deregulation. Interestingly, however, there has been a growing disconnect between this consumer and business confidence (soft data) and tangible, hard economic data (i.e. employment, housing, business activity). In other words, the positivity surrounding President Trump’s policies have yet to show up in real economic data.
In many respects, this is not all that surprising. The Trump administration has yet to push through an infrastructure spending bill or tax reform plan, so the impact has not been felt in the broader economy. Also, if and when these come to fruition, the potential benefits may still take time to filter through to the economy – the effects could be more 2018 or 2019 than 2017. In the short-term, there could be some immediate impact – just the anticipation of government spending and tax cuts can help spur consumers and business to spend, knowing better days may be around the corner – but that has yet to be reflected in the data.
All of this is a long-winded way of saying that while there is an abundance of optimism hinging on Trump’s pro-growth agenda, the proof will be in the pudding. While current data and expectations from economists, financial markets, consumers, and businesses point to confidence that Trump will be able to deliver, nothing is assured. Hillary Clinton, the Atlanta Falcons, and the producer of “La La Land” will all attest to the fact that defeat can be snatched from the jaws of victory. President Trump will need to successfully navigate a winding political process to deliver on an agenda the economy and markets now seem to fully expect. It is notable that President Trump has already experienced some of the challenges he will face in governing with his attempt to repeal and replace the Affordable Care Act. Given the highly polarized political environment, pushing through an infrastructure spending package or tax cuts will likely prove equally challenging.
So what is the takeaway for investors? Market returns during the first quarter were strong, driven largely by the aforementioned optimism. If Trump is able to deliver, an intelligent case can be made for further gains. However, if political wrangling devolves into inaction, uncertainty will creep back into the picture and concerns over stock valuations and future economic growth may intensify. If we learned anything from the first quarter of 2017, it is to assume nothing until it is done. Our hope is that politicians will work together to deliver a prosperous future for our country. Beyond that, the current political landscape in the U.S. is yet another reminder of why it is important to diversify internationally. The top performing markets during the first quarter were found outside of the U.S., as overall global economic growth has steadily improved. While attention is naturally focused on U.S. markets and politics, global opportunities are always present and can serve as an excellent diversifier.
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