Settling The Share Class Debate

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[This article previously appeared in Exchange-Traded Funds Report .]

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ETFs are a better mousetrap.

That’s the saying, at least. And while proponents of ETFs always point to their low expenses first when discussing their advantages, the second calling card is always tax efficiency. ETFs, we’re told, are vastly more tax-efficient than mutual funds.

The data support this. In 2010, the largest ETF issuer in the world—iShares—paid out capital gains on exactly five of its 219 ETFs. PowerShares, another big player, went three for 112. Most mutual fund companies would weep for those records.

That tax efficiency is no accident, proponents say. Instead, it’s a core feature of the product, driven by the key underlying features of how ETFs work.

ETF Tax Efficiency Explained
To understand the pro-ETF argument, think about what happens when an investor sells out of two products:a mutual fund and an ETF.

When you sell shares in a traditional mutual fund, that fund usually pays you in cash. If the fund doesn’t have enough cash on hand, it may have to go into the market and sell some of its holdings to raise cash to pay you. If the securities it sells have appreciated in price since the time that the fund bought them, that sale will generate capital gains, which may have to be paid out in a taxable distribution at the end of the year.

When you sell shares of an ETF, however, you sell them on the open market to another investor. The ETF company doesn’t know, and doesn’t care, that you’ve sold. There is no reduction in the assets for the fund, so there is no need for the portfolio manager to sell shares to raise cash. If a lot of investors sell at once, that will push the price of the ETF below its fair market value. And that’s where the secret sauce comes in.

When ETFs dip below fair market value, a group of institutional investors called authorized participants (or APs) will “redeem” shares from the issuer. That is, they will buy up blocks of the ETF (typically 50,000 shares) and turn them in to the ETF issuer. In exchange, the issuer will give them the full, fair value of the underlying securities. This is a risk-free arbitrage profit for the AP, who buys the ETF shares at a discount and redeems them at fair value. But it’s also a good deal for the ETF, because the ETF can actually pick which share lots it will pass back to the AP. Not surprisingly, it will tend to pick shares with the most capital gains. That helps cleanse the fund of potential gains.

Mutual funds can do this too, but to a much lesser extent.

The Vanguard Debate
All this has created a conflict in the ETF industry, because the third-largest ETF provider—Vanguard—does not operate like the rest. While most ETF issuers operate their funds as discrete pools of assets, Vanguard operates its ETFs as share classes of existing mutual funds. In other words, a fund like the Vanguard Emerging Markets ETF (NYSE Arca:VWO) provides access to the same pool of assets as the Vanguard Emerging Markets Stock Index Fund (NYSE Arca:VEMAX).

For most of the past decade, the two sides have railed at each other about this share class structure. Detractors argue that Vanguard’s share class structure pollutes the tax efficiency argument; that is, if masses of investors redeemed money from the mutual fund share classes, the ETF share class would be on the hook for the capital gains that ensue.

Vanguard, for its part, has argued that the ETF tax efficiency argument is overblown, and that the inherent tax efficiency of index funds overwhelms any ETF-specific advantages. It has even argued that its share-class structure may be more tax-efficient, as it allows the firm to combine the best tax advantages of the ETF structure with a few tax tricks that only work for mutual funds. The firm put out a paper in June comparing the tax efficiency of Vanguard, SSgA, and iShares ETFs, hoping to settle the debate in its favor.

IndexUniverse decided to compile its own data on the topic and see how the data shook out. The goal was to answer the question of what truly contributes to ETF tax efficiency.

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Making Comparisons
To truly compare apples to apples, it’s important to control as many factors as possible. Investor redemptions aren’t the only way that funds can generate capital gains, after all:Index changes, corporate actions, or rebalancing schedules can also generate gains.

To place things on an apples-to-apples basis, we began our study by looking only at market-cap weighted domestic ETFs operating in the same capitalization tiers and style categories. We examined all ETFs that fit this description, looking back over the past 10 years, using the IndexUniverse ETF Classification System to divide ETFs into the appropriate buckets.

Figure 1 shows payouts by fund years. A fund that’s been in the market for 10 years contributes “10 fund years” to the analysis. A new fund would contribute just one fund year. A gain in a given year counts as one fund year, and a single fund can have multiple years when it paid gains.

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Figure 1

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Looking at the results, the first thing you see is that capital gains payouts are rare. A little more than 3 percent of ETFs distributed gains in any given year, a paltry number that speaks well to the ETF industry as a whole.

Growth and value funds were more likely to have payouts than broad-based ETFs. That’s not surprising, as growth and value funds tend to change components more than broad-based funds over the course of a year.

In addition, payouts increase in likelihood the farther down the capitalization spectrum you go. This is intuitive as well, as there’s simply more movement across the small/mid boundary than there is between the mid and large. GE likely won’t get ousted from the S'P 500 anytime soon.

But what about weighting schemes? The IndexUniverse ETF Classification System groups the 187 funds in our study by the following weighting methodologies:Beta, Dividend, Earnings, Equal, Fundamental, Market Cap, Momentum, Multi-Factor, Price, Proprietary, Revenue, Tiered and Volatility (See Figure 2).

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Figure 2

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Of the 13 categories, ETFs using Dividend weighting strategies had the highest percentage of years with capital-gains distributions—8 percent of the available fund years resulted in a distribution. Equal weighting did not fare much better, with 5.71 percent of payout years. Multi-Factor and Market Cap came in third and fourth, with 3.33 percent and 3.10 percent, respectively.

It’s worth noting that many of the weighting methodologies tested here are new. Beta- and Volatility-weighted funds, for instance, didn’t actually have valid years in the study, and the number of years for many other strategies was small.

Moreover, many of the payouts were vanishingly small. The Dividend-weighted products, for instance, had an average payout of just 0.22 percent of NAV … hardly something to get worked up about.

In general, the average distribution for these funds was just 0.77 percent—a tiny number. The sample size is limited, but the findings suggest that the ETF promise of tax efficiency holds.

Interestingly, in our study, the use of a non-market-cap weighted methodology did not have a detrimental effect on tax efficiency. Taken together, just 2.20 percent of non-market-cap weighted funds paid out gains in a given year, compared with 3.06 percent among cap-weighted funds.

Comparing Issuers
What of Vanguard and the share class assessment?

To evaluate this, in Figure 3, we looked at capital gains distributions on an issuer-by-issuer basis.

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Figure 3

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Vanguard indeed looks superb:With 97 tax years in the sample, Vanguard never paid a capital gain.

Neither, however, did many ETF issuers with traditional ETF share classes, including BlackRock (332 fund years with zero payouts), PowerShares (92 fund years, zero payouts), and First Trust (50 fund years, zero payouts).

Our findings here differ somewhat from the research Vanguard presented in its June white paper. That’s because the data reflected a small oversight, according to Vanguard’s Joel Dickson, Ph.D., one of the authors of the paper:“It turns out that the data source that we used combined return of capital distributions with capital gain distributions,” he said. Vanguard said it plans to update its table to reflect the new analysis in a future white paper.

More broadly, of the 19 issuers included in our data, only six had capital gains to distribute over the 10-year period.

High percentages from ALPS and FaithShares are potentially misleading due to small sample size. The Fidelity payouts are concentrated in its one fund, the Fidelity Nasdaq Composite Tracking Stock ETF (NYSE Arca: ONEQ).

The surprising data come from SSgA, with 16 payouts over 110 fund years. Even here, the payouts are hardly earth-shattering:Seven of State Street’s 16 payouts in the 10-year period are concentrated in a single fund—SLYV, the SPDR S'P 600 Small Cap Value ETF. SLYV has historically had low trading volume relative to its creation unit size (50,000 shares). That makes it difficult for the redemption process to help mitigate capital gains, effectively limiting the tax advantages of the ETF share class structure for that fund.

The other SSgA payouts were concentrated in the 2006–07 tax years. Since then, the firm has a nearly perfect record in its domestic-equity funds.

SSgA was not available for comment.

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Conclusions

Taken together, does this suggest the Vanguard structure is better or worse than its peers?

Neither.

Vanguard has an exemplary record of managing its domestic-equity funds for tax efficiency over the past 10 years. So do iShares, PowerShares and a number of other providers. The tendency toward payouts seems to be more idiosyncratic, tied to issuers and trading volume rather than share class structure.

Looking at the numbers, one has to wonder if capital gains distributions are quite the bogeyman they’re made out to be.

“I think that people have been way, way too focused on capital gain distributions as the measure of so-called tax efficiency,” said Dickson. “Sometimes we do get too focused on the actual distribution and forget all of the other things that matter in terms of the after-tax return that an investor receives.”

Dickson says pretax return and tracking error (including the expense ratio of a fund) should play a far bigger role in determining tax efficiency than monitoring the occasional cap-gains payout. We would agree.

Taken together, the data suggest that ETFs are extraordinarily tax-efficient, regardless of structure. There was no substantial difference between issuers like iShares and Vanguard, suggesting that the difference between the share class structure and the non-share class structure simply has had little impact on the realized tax efficiency of a given ETF, at least within the domestic equity market.

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Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 IndexUniverse LLC . All Rights Reserved.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: ONEQ , VWO

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