Investors in exchange-traded funds don't normally have to fret about tax bills, because tax efficiency is one of the main sales pitches right along with transparency, liquidity and lower fees.
But thanks to recent adjustments in certain indexes that some ETFs track, the threat of a tax bill has forced some ETF providers into scramble mode to try and limit the fallout — the full extent of which remains unclear.
In essence, when S&P Dow Jones Indices and MSCI Inc.
created an eleventh sector in September by separating real estate from financials, $30 billion worth of financial-sector ETFs had to figure out how to cleanly remove nearly $6 billion worth of real estate exposure.
How the handful of firms most impacted by the index shift managed the challenge says plenty about the ingenuity in the ETF space, especially when there was no blueprint to follow.
But it also says plenty about a
reality of passive-ETF investing: The indexed ETFs are mandated to track the benchmark, no matter what.
State Street Global Advisors, manager of the largest financial sector ETF, the $14 billion Financial Select Sector SPDR (XLF), is trying to dampen the tax impact by moving the real estate holdings into the Real Estate Select Sector SPDR (XLRE).
For investors in XLF, their exposure to financials and real estate will not change, but by shifting 20%, or about $3 billion, of the financial-sector ETF into the real estate ETF,
they will feel the pinch of a tax similar to a dividend distribution.
According to Dave Mazza, State Street's head of ETF research, 74% of the distribution to the real estate ETF will be counted as a return of capital, and 26% will be taxed as ordinary income.
“We find this method to be fairly tax efficient, but we won't know the exact details until after the fiscal year ends Sept. 30,” he said.
Managing the ETF representing roughly half of all the financial-sector ETF assets,
State Street had the unique challenge of navigating both the tax consequences on investors and the impact on the market of selling the real estate holdings.
“There was a consideration to just sell the real estate, but the idea of selling $3 billion worth of securities indiscriminately on one day was not an attractive option to us,” Mr. Mazza said. “We looked at the impact and what it would do to the share prices.”
Guggenheim Investments followed a strategy similar to State Street's by carving out the real estate exposure from its $106 million Guggenheim S&P 500 Equal Weight Financial ETF (RYF), and distributing it to investors through the Guggenheim S&P 500 Equal Weight Real Estate ETF (EWRE).
Because of the smaller size of Guggenheim's fund, the market impact was less significant than were the tax consequences, and a company spokesman confirms that it is not yet clear what the ultimate tax impact will be.
For its part,
The Vanguard Group trimmed its real estate exposure from the $3.2 billion Vanguard Financial ETF (VFH) by selling the holdings, and essentially treating it like an index rebalancing.
Rich Powers, head of ETF product development at Vanguard, said he is not anticipating a taxable event for shareholders because the sale of the real estate securities will be offset by realized capital losses in the fund.
“This is probably one of the larger changes we've seen to an index in the last 15 years,” Mr. Powers said. “But it was kind of a push in terms of the tax impact.”
Fidelity Investments didn't directly respond to a request regarding its $234 million Fidelity MSCI Financial ETF (FNCL), but an email response from the company suggests it is following the Vanguard approach of treating the changes like an index rebalancing.
The statement from Fidelity begins by confirming that “it's too early to say what the tax implications will be of any repositioning.”
Truer words might never have been spoken.
As Todd Rosenbluth, director of ETF research at S&P Global Market Intelligence, put it, investors have been groomed to expect the ETF structure to be highly tax efficient.
“It's a relatively big deal, because investors will likely see greater than the zero capital gains tax they were expecting,” he said.
Regardless of how the various ETF providers have hustled to try and limit the impact, Brian Mackey, senior research analyst at Adviser Investments, said it exposes the “Achilles heel of index investing, in general.”
“Without any ability to do otherwise, they have to make the change to keep tracking the index,” he said. “I have no doubt the ETF providers are doing all they can, but they have to follow the index, that's the difference between active versus passive.”
