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ETFs: 'T' is for tax

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While short and leveraged exchange-traded funds offer some of the same benefits as traditional ETFs, there are reasons for caution.

“Unlike other ETFs, leveraged and short ETFs do not use a portfolio of exchange-traded assets to track their benchmark index,” writes John Gabriel, an ETF analyst for Morningstar. “Instead, they keep their assets in a pool of cash and enter custom swap agreements to produce the desired returns.”

If a fund’s assets start to shrink, managers must sell derivatives instead of passing them on, leading to what can amount to big capital gains payments. As an example, Gabriel points to the Rydex Inverse 2x S&P Select Sector Energy fund, which paid about 74 percent of its NAV in capital gains distribution.

As far as tax advantages go, Gabriel equates short and leveraged ETFs with traditional open-end mutual funds, and offers this tip for traders: “[T]hough many funds have already made their distributions, nimble traders can avoid some of the tax bite by dumping their shares ahead of the posted ex-date.”