Lipper Research Senior Analyst Tom Roseen on "Business for Breakfast" 1060 KRCN - Tax Efficiency of ETFs
Q. Tom Roseen, another senior research analyst at Lipper, is sitting in forDon Cassidy with us this morning.Tom, we understand Lipper has recently done a study on the tax efficiencyof ETFs?
A. Right. And maybe we should step back just a minute and first define whatan ETF is.
Q. Good point. Go ahead.
A. Well, the definition is starting to get blurry because of some recentnew issues, but nearly all exchange-traded funds (ETFs) are index-basedbaskets of stocks or bonds that trade on a stock exchange all day long,rather than being sold and redeemed only after the close by the sponsoringadvisors like a mutual fund is.
Q. Sounds sort of like a closed-end fund?
A. Somewhat, yes. But there are two key differences: ETFs are staticbaskets, or index products, so the cost is very low. And they have someunique structural features allowing arbitrage, so they virtually nevertrade at more than about a half-percentage-point premium or discount, whileclosed-end funds (CEFs) can trade at big variances from their underlyingnet asset values (NAVs).
Q. Okay. So you have been looking at their tax efficiency?
A. Right. There are some technical details in how ETFs transact with theirinstitutional holders, which result in their fairly seldom havingreportable net capital gains that get passed along to retail buyers.
Q. Yes, I recall seeing a recent press release from the iShares brand,stating it paid no capital gains again in 2005.
A. That was true, but it is not guaranteed.
Q. What have you found? For example, what percentage of ETFs in a givenyear typically pay cap gains?
A. Of course it varies by year, with little if any in the bad market yearslike 2002, but it is not guaranteed?From 1997 to 1999 between 75% and 90% of ETFs paid out capital gains. In2000, a horrible year for equity returns, about 41% of ETFs made a payout.But since 2000 that number has declined dramatically. Over the last fiveyears on average just 3% of the funds made capital gains payouts. Forexample, in 2005 only five ETFs paid out capital gains:
- streetTRACKS Dow Jones STOXX 50 Fund
- streetTRACKS DJ Wilshire REIT ETF
- streetTRACKS DJ Wilshire Small Cap Value ETF
- Fidelity NASDAQ Composite Index Tracking Stock
- Vanguard REIT Index Fund;VIPER
Q. What determines whether an ETF will have a reportable net capital gain?
A. As I said, certainly the market trend is a factor. But there can beother individual events that can trigger gains.
Q. Like what?
A. The most common event is when a stock in the basket becomes a cashtakeover. That?s good news from a profit viewpoint, but it triggers aninescapable tax event.
Q. You said the most common? are there other triggers that would make anETF not as tax-efficient as people expect?
A. Yes, but they are not very common. There is a diversification rule thatsays any kind of fund can?t hold more than 25% of its assets in oneissuer?s securities. If one stock does extremely well, it could hit thatbarrier, and the ETF would be forced to sell down some of the stock to staybelow the 25% limit.
Q. Can you give an example?
A. Back in August 2000 Nortel Networks in the iShares Canada ETF (tickerNYSE:EWC) had a huge price run. And it had already started out as a majorweight in the index. So, iShares had to sell off some of Nortel, whichcreated a cap gain equal to about 22% of the total fund value. Anexception, but it can happen!
Q. Any other aspects of tax efficiency that investors should be aware of?
A. Yes, actually. Most people speak or think in terms of gains taxefficiency, but there is also an income aspect. Since ETFs generally havelower expenses than a regular mutual fund, they are more likely to pay outnet investment income (the dividends they get, less expenses). So, they area little less efficient in that sense. But of course a dollar of income youdo get versus one you do not is still a better deal.
Q. Doesn?t Lipper?s free Web site lipperweb.com cover tax efficiency?
A. It sure does; listeners can go to lipperweb.com and screen or reviewtheir funds based on criteria that are important to them: tax efficiency,total return, consistent return, preservation of capital, and expenses.
Q. Thanks, Tom.
A. Glad to join you!
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