Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering a taxable event. Although very rare, ETFs have capital gains from time to time due to one-time large transactions or unforeseen circumstances. Because ETFs are structured as registered investment companies, they act as pass-through conduits, and shareholders are responsible for paying capital gains taxes.
Exchange-Traded Funds
ETFs invest in individual securities, such as stocks, bonds and derivatives with specific investment objectives. Typically, ETFs are passively managed, where they follow a certain equity or bond index and only rebalance their portfolios when significant changes occur to the underlying benchmark. Shares of ETFs are traded like stocks on major U.S. stock exchanges, such as the NASDAQ and the New York Stock Exchange.
ETFs became very popular among investors due to their transparent and simple investment strategies and low expense ratios. As of December 2014, there were 1,411 ETFs registered in the United States with total net assets of approximately $2 trillion, representing 13% of total net assets under management of mutual funds, ETFs and other trusts and closed-end funds.
Capital Gains of ETFs
Holding ETFs in a taxable account typically generates less capital gains when compared to mutual funds, because ETFs do not necessarily have to sell the underlying securities to finance investment inflows and outflows. Through authorized participants, ETFs can create or redeem “creation units,” which are blocks of assets that represent an ETF’s securities exposure on a smaller scale. By doing so, ETFs typically do not expose their shareholders to capital gains.
Occasionally, an ETF may incur a capital gain due to some special circumstances, where it has to drastically rebalance its portfolio due to substantial changes in the underlying benchmark. Also, leveraged, inverse and emerging market ETFs typically cannot use in-kind delivery of securities to create or redeem shares. This triggers capital gains more often for these kinds of ETFs when compared to index ETFs.