From the November 2011 issue of Research Magazine • Subscribe!

Making Tax Savvy Choices

Tax efficiency has long been sold  as among the greatest advantages of ETF investing. Although that may have been true ten years ago, when most ETFs were linked to traditional stock and bond indexes, it isn’t necessarily true anymore.

Since their infancy in the early 1990s, the dynamics of investing in ETFs have changed dramatically. This has been led by the ETF industry’s expansion into new asset classes like commodities and currencies along with product structures that resemble ETFs but aren’t technically ETFs. For this reason, it’s wrong for advisors and their clients to assume that all products with the ETF label are automatically tax efficient beasts.

How can you make tax savvy investment decisions? Know what you’re buying.

In response to the broadening reach of ETFs, this very column has been changed to adapt with the times. It’s now called “ETP Reporter,” because “ETP” encompasses not just ETFs but products that trade in the same fashion and yet utilize a different structure.

Among the non-ETF products that fall under the ETP heading are grantor trusts, partnerships and exchange-traded notes (ETNs). These product types are well suited for asset classes like commodities and currencies, and they have helped financial advisors to build investment portfolios that diversify beyond stocks, bonds and cash.

Yet, while ETPs are sometimes referred to as “ETFs” by the mainstream media it’s important to understand they may not necessarily have the same friendly tax treatment as traditional ETFs. Let’s evaluate the taxation of popular ETP structures. In each of these examples, we will assume these investments are being held in taxable investment accounts.

Grantor Trust

The Grantor Trust is a financial structure typically used by commodity or currency focused ETPs. The SPDR Gold Shares (GLD), iShares COMEX Gold Trust (IAU) and the iShares Silver Trust (SLV) are noteworthy examples of ETPs that use the grantor trust architecture.

Some investors fool themselves into thinking the ETP label is giving them a tax break on their investments in gold or silver, but this is hardly the case.

ETPs that hold physical bullion, like GLD or SLV, are taxed at a maximum capital gains rate of 28 percent, which is higher compared to other investments, like stocks. Under current tax law, profits from securities are taxed at a maximum long-term capital gain rate of zero percent for those in the 10 or 15 percent income tax bracket and 15 percent for people in higher brackets.

Grantor trusts with physical metals do not distribute realized capital gains nor do they generate interest income. However, there’s always an outside chance your clients might receive a K-1 or a Form 1099, so always keep on the watch.

ETPs Invested in Futures

Many grantor trusts and partnerships hold futures contracts on currencies or commodities. For instance, the iShares S&P GSCI Commodity Indexed Trust (GSG) contains futures contracts on 24 commodities including corn, gold, live cattle, oil, natural gas, soybeans and wheat. How are they taxed?

Commodity linked products that utilize futures to obtain their market exposure are taxed at a 60/40 rate, regardless of the holding period. Thus, 60 percent of gains are taxed at the long-term capital gains rate while the remaining 40 percent are taxed as short- term profits, subject to the investor’s ordinary income tax rate. For investors in the highest tax bracket, this 60/40 split creates a maximum blended capital gains tax rate of 23 percent. The tax burden is reduced for investors in lower income brackets.

Finally, an investor in these types of products may be taxed each year, even if they do not sell the investment. Likewise, interest income must be recognized.

Exchange-Traded Notes

Commodity and equity linked ETNs are taxed as prepaid contracts. This means investors incur tax consequences only upon the sale, redemption or maturity of their note. If held to maturity, the future payment of the contract is dependent on the value of the underlying benchmark index.

While ETNs linked to commodities or stocks are lauded for their tax benefits, the IRS has already taken a swipe at currency ETNs.

In 2007, the IRS issued an adverse tax ruling on currency linked ETNs stating that financial instrument linked to currencies should be treated like debt for federal tax purposes. Put another way, all gains from a currency ETN, including interest, are taxed at ordinary income tax rates. What does this mean for commodity and stock linked ETNs? A future of higher taxes looks like a realistic possibility.

Leveraged ETFs

ETFs that use leverage or provide inverse performance do not necessarily have the same level of tax efficiency as plain vanilla ETFs like the SPDR S&P 500 (SPY) or the Vanguard Total Bond Market ETF (BND).

Unlike SPY or BND, leveraged and short ETFs do not use a portfolio of stocks and bonds to track their underlying benchmarks. Instead, they buy derivatives or swap agreements and leave the remainder in a cash pool. That means when an authorized participant creates or redeems shares in an ETF like the Direxion Daily 20+ Yr Treasury Bear 3x Shares (TMV), they are exchanging their shares for a specified amount of cash as opposed to a basket of securities.

Here’s another twist: The derivatives utilized by leveraged and inverse funds aim for daily returns and are thus taxed at short-term capital gains rates. Owners of leveraged or inverse ETFs with holding periods that exceed one year can still get stuck with short-term capital gains.

What happens if the leveraged or inverse ETF faces large net redemptions? It could force the ETF manager to sell some of their derivatives or swaps, which could result in unexpected capital gains for remaining shareholders. Also, the interest paid on the cash investments the ETF holds is taxable as ordinary income even if your client continues to hold the fund.

None of these are reasons to avoid these types of ETFs, but rather, to use them in a manner that matches your client’s investment goals. Leveraged and short ETFs are still good tools for short-term trading hedges or bets.

Location! Location! Location!

Beyond employing good asset allocation, more advisors should be practicing smart asset location. In real estate, it’s said the most important aspect of making a successful investment is location, location and location. With an investment portfolio, it’s similar.

How can you reduce a client’s tax liability with asset location? This can be accomplished by putting tax inefficient asset classes like bonds and REITs inside tax sheltered retirement accounts. Since bonds and REITs produce most of their gains from dividends, which are taxed at higher ordinary income rates, it’s ideal to keep them positioned in an IRA, Roth IRA or 401(k) account.

This same asset location principle applies to grantor trusts that own physical precious metals or futures contracts on commodities or currencies. Investors are shielded from the higher tax bill of keeping these investments inside taxable accounts. In contrast, plain vanilla ETFs that invest in a basket of stocks, typically have low tax liabilities and can be held in a taxable investment account.

Summary

Are ETFs really tax efficient? In the past, we could say “yes,” but with the invention of ETPs that use complex financial structures and sophisticated tracking methods, the answer is less straightforward. Ultimately, it’s up to educated advisors to understand these nuances in order to lower their clients’ tax bills.

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