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Capital Gains drag on mutual funds and etfs

6K views 25 replies 11 participants last post by  FI40 
#1 ·
Once upon a time when I was learning how to ditch my financial advisor I read some articles about capital gains taxes affecting returns on mutual funds and etf returns. If I remember correctly the theory was that purchasing funds at year end was a bad idea as most portfolio managers had a higher portfolio churn at that time of year. I also read that year end was the time that many funds pulled $ at year end to cover taxes on capital gains. As a result those purchasing later in the year were paying on gains the fund made throughout the year. I have always been a stock picker as I find it suits my style better than couch potato. That being said I am considering investing my RESP dollars (currently 100% cash into funds instead of equities). Should I be concerned with what I mentioned above? Is there any truth to it? Thanks in advance.
 
#3 ·
The issue is only applicable in non-registered (taxable accounts) per Soon Forget.

The issue in taxable accounts is primarily with mutual funds (in particular) that only issue distributions at the end of each calendar year. The distributions include income earned throughout the year, including internal realized cap gains. Whether you owned the mutual fund for the full year or for only December, the fund issues distributions equally to every unitholder. So if the mutual fund issues a distribution of $1/unit in December, the NAV of the fund drops by $1 in equivalence and your T3 tax slip issued in March 2016 will show this $1 as income. It is less of an issue with mutual funds and ETFs that issue distributions monthly or quarterly because most of the effect would have been distributed throughout the year. albeit the 4th quarter distribution can have a cap gains surprise.
 
#4 · (Edited)
Thanks for the responses.

I believe what I was asking about is addressed in this article

http://news.morningstar.com/articlenet/article.aspx?id=715686


"Don't: Sell pre-emptively to dodge a distribution without considering the other tax consequences.
That said, selling long-held funds pre-emptively doesn't often add up, because you may cost yourself more in taxes than you would pay on the distribution alone. The reason is that fund investors face two layers of capital gains taxes: the taxes they incur with their own buying and selling, as well as the taxes they owe on the distributions. So, you may dodge the distribution with a sale, but if your cost basis is below your sale price, you'll owe capital gains on the differential."

That being said if it distributes annually does it matter whether the purchase is made before or after distribution in a registered account? My guess is no but I am a total noob when it comes to mutual funds and etfs. The only thing I know is they made my last financial advisor $ at my expense.

Cheers
 
#11 ·
any ETF or fund with any foreign holdings can undergo a re-org of one or more of its holdings that is interpreted by canadian tax authorities as a capital event that triggers capital gains tax.

i believe there used to be a time when certain foreign re-orgs (US is included among foreign) were interpreted as 100% income events. This used to give rise to screams of pain among canadian investors, goes my understanding. Eventually the CRA modified its view & came to regard certain foreign re-orgs as capital reorganizations.

afaik the tax authorities would not discriminate as to whether a foreign re-org would be held by an ETF or a traditional mutual fund.

it's unpredictable, wholly out-of-control events like the above that boost my aversion to ETFs & funds, btw.

re securities having to be sold to meet redemption demands: this would be rare, imho. A devouring of capital would only occur during a global financial collapse i believe.

routine redemptions would be paid out of new investment monies coming in plus whatever dividend & interest incomes would have accrued. A properly managed ETF or fund would keep a pool of cash on hand to fund anticipated redemptions.
 
#13 ·
Vanguard is the exception to the rule. They have actually patented that business process. http://www.etf.com/sections/blog/4280-active-etfs-vanguard.html

Capital gains distributions you see in ETFs are due to rebalancing transactions. MFs have those, as well as transactions to allow for fund flows into and out of the fund as units are created and redeemed.

securities having to be sold to meet redemption demands: this would be rare, imho. A devouring of capital would only occur during a global financial collapse i believe.
ETFs don't have to worry about this--it's up to the market-maker or other APs to create or redeem units of an ETF. These are in-kind transactions, not cash transactions, so do not trigger gains within the ETF.

MFs on the other hand regularly grow and shrink more than can be absorbed by a small cash allocation (and not just during times of extreme market stress), and redemptions may have to be financed by asset sales. Managers I'm sure try to minimize the capital gains that are realized as a result.

Here's an explainer:

http://www.etf.com/etf-education-center/21017-why-are-etfs-transparent-and-tax-efficient.html

Greater Tax Efficiency

ETFs are vastly more tax efficient than competing mutual funds.

If a mutual fund or ETF holds securities that have appreciated in value, and sells them for any reason, they will create a capital gain. These sales can result either from the fund selling securities for a tactical move, due to a rebalancing effort, or to meet redemptions from shareholders. By law, if funds accrue capital gains, they must pay them out to shareholders at the end of each year.

This is no joke. Between 2001-2011, the average emerging markets equity mutual funds paid out 6.46 percent of their net asset value (NAV) in capital gains to shareholders, every year.

ETFs do much better (for reference, the average emerging market ETF paid out 0.01 percent of its NAV as capital gains over the same stretch).

Why? For starters, because they’re index funds, most ETFs have very little turnover, and thus amass far fewer capital gains than an actively managed mutual fund would. But they’re also more tax efficient than index mutual funds, thanks to the magic of how new ETF shares are created and redeemed.

When a mutual fund investor asks for her money back, the mutual fund must sell securities to raise cash to meet that redemption. But when an individual investor wants to sell an ETF, he simply sells it to another investor like a stock. No muss, no fuss, no capital gains transaction for the ETF.

What happens when an AP redeems shares of an ETF with an issuer? Actually, it gets better. When APs redeems shares, the ETF issuer doesn’t typically rush out to sell stocks to pay the AP in cash. Rather, the issuer simply pays the AP “in kind”—delivering the underlying holdings of the ETF itself. No sale means no capital gains.

The ETF issuer can even pick and choose which shares to give to the AP—meaning the issuer can hand off the shares with the lowest possible tax basis. This leaves the ETF issuer with only shares purchased at or even above the current market price, thus reducing the fund’s tax burden and ultimately resulting in higher after-tax returns for investors.

The system doesn’t work so smoothly for all ETFs. Fixed-income ETFs, which have more turnover and often have cash-based creations and redemptions, are less tax efficient than their equity brethren.

But all else equal, ETFs win hands-down, with two decades of history showing they have the best tax efficiency of any fund structure in the business.
 
#15 ·
Something I've been wondering about for a while somewhat new to ETFs, always been a dividend investor. But say for example you own iShares Core S&P/TSX Composite High Dividend Index ETF (XEI) and last year it paid out 79 cents in capital gains. Does that mean that amount is the deposited into your account?
Secondly like any dividend stock, if I buy it just before the record date does that mean I’d get the capital gain in spite of the fact I may have only held it for a few days?

I’m assuming an ETF is like a stock in that just before it goes ex dividend the price drops by roughly the amount of the dividend.
 
#16 · (Edited)
Something I've been wondering about for a while somewhat new to ETFs, always been a dividend investor. But say for example you own iShares Core S&P/TSX Composite High Dividend Index ETF (XEI) and last year it paid out 79 cents in capital gains. Does that mean that amount is the deposited into your account?
Depends ... in most cases, it will be cash paid into one's brokerage account.

The "phantom distributions" mentioned in post #14 are where some/all of the capital gain is *not* paid as cash but is reported on the T3 as a CG. It was re-invested in the ETF then the units consolidated so that the investor has the same number of units.

In this case, the investor has to remember to add the re-invested amount to their ACB ... otherwise they pay CG taxes in that year from the T3 and then pay CG again as their ACB has not increased despite the CG being re-invested (i.e. similar to buying more units).

It is something to pay attention to as someone who bought ETF XIU in 1999 and still holds it has experienced eleven phantom distributions totaling over $6.19 per unit. It is more common than people think those tracking it say that in 2011, thirteen iShares ETFs of forty eight paid them and twenty of BMO's forty two ETFs paid a phantom distribution.


Secondly like any dividend stock, if I buy it just before the record date does that mean I’d get the capital gain in spite of the fact I may have only held it for a few days?
The CG that's tied to the cash paid will be what one gets. The key here is if the CG is all paid as cash then where one has held the ETF for the last two months of the year ... only payments in the last two months will be reported on the T3.

In contrast, where the MF does a once a year distribution at the end of the year, potentially one will have to pay the full year's worth of CG despite only participating in the benefits from the MF of the last two months.

I'm not clear on the timing of phantom distributions (I suspect this would done at year end so it might be similar to the MF).


I’m assuming an ETF is like a stock in that just before it goes ex dividend the price drops by roughly the amount of the dividend.
Yes.


Cheers
 
#17 ·
I wasn't aware of the structure change in XEF when I bought it last year, and got nailed with a big "phantom" distribution that essentially was as if I had sold and rebought the security - my cost base got increased and I had to pay cap gains tax on about 3k in gains. Ironically the only reason I was in XEF was because I switched out of VDU to harvest some cap losses.

At least I did my taxes properly thanks to PWL capital's whitepaper.

I guess it's alright though, these changes don't happen that often and they happen for a reason (iShares was buying underlying securities rather than a wrapped fund in an attempt to reduce fees, I believe).
 
#18 ·
Without having a history of the particular ETF, I am not sure how confident I'd be that it does not happen often.
Having eleven phantom distributions over sixteen years as the popular ETF XIU does not match my idea of "not often".

I'm glad I have all my ETFs in registered accounts so at this point, I don't have to worry about it.


Cheers
 
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