ETF Prime Archive

Beware of Mutual Fund Capital Gain Distributions

As the end of 2011 quickly approaches, it’s time to start considering the tax consequences of investments you hold in taxable accounts.  One of the biggest benefits ETFs provide investors is they can cut your tax bill.  Because of their legal structure and minimal trading, ETFs typically distribute very little, if any, capital gains to investors.  In contrast, many mutual funds distribute capital gains – sometimes even if the mutual fund is down for the year!

So, why is this case?  Take the following example:  Let’s say there’s a mutual fund shareholder that wants to sell their mutual fund shares because they need cash to buy a house.  The mutual fund manager may need to sell shares of stocks held by the fund to raise cash to meet this shareholder redemption request.  When the mutual fund manager sells shares of stocks owned by the fund for a gain, the mutual fund is required to distribute those gains to all mutual fund shareholders.  So to recap, if you’re a shareholder of the mutual fund and another shareholder redeems their mutual fund shares, you may be penalized with a taxable capital gain distribution even though you didn’t do anything.  That hardly seems fair.  And what’s worse, these capital gain distributions are “phantom gains” in that the share price of a mutual fund is reduced by the amount of the capital gain distribution.  So net-net, shareholders haven’t gained anything other than a tax bill.

Contrast that with ETFs where a shareholder wanting to raise cash can simply sell their shares on the stock exchange with no impact to you.  There are instances where ETFs may reconstitute or rebalance holdings, thus generating a capital gain distribution, but those instances are rare.  For example, iShares – the largest ETF provider, recently announced that 99% of their ETFs (231 of 233) are not expected to pay capital gain distributions to shareholders this year.  In fact, over the last 10 years, 99% of the time iShares funds have not paid capital gains.

So, what can you do to protect yourself?  If you must buy a mutual fund, wait until after the fund pays out its capital gains before you buy.  You can generally check with the mutual fund provider website to find that date.

If you already own a fund and it hasn’t yet paid its capital gains distribution, you can avoid the distribution and still retain much of the performance of the fund by selling the fund and buying a highly correlated ETF that tracks the same or a similar benchmark.  You can use ETF Database’s mutual fund to ETF converter tool here to help you in that process.

ETF Store Show Recap – 11/05/11

Listen to The ETF Store Show every Saturday at 4pm on KCMO Talk Radio 710AM as we cover everything you need to know about Exchange Traded Funds and the world of investing.

On our most recent radio show, we explained why the European Debt Crisis matters to your investments and suggested some ways that you can navigate through these volatile markets.  We also discussed the following topics:

• How to generate income in your portfolio using ETFs
• Investing in an individual stock versus an ETF that holds that particular stock

Listen to the full show here.

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ETF Store Show Recap – 10/29/11

Listen to The ETF Store Show every Saturday at 4pm on KCMO Talk Radio 710AM as we cover everything you need to know about Exchange Traded Funds and the world of investing.

On our most recent radio show, we discussed the recent surge in both the equity markets and the price of gold and suggested some gold ETFs you might want to consider.  We also spent some time answering a number of questions we commonly receive regarding ETFs.  Among the questions we covered were:

• What do ETFs actually own?
• Do ETFs pay dividends and interest?
• Are ETFs any riskier than mutual funds?

Get the answers to these and other ETF related questions by listening to the full show here.

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