Do actively managed ETFs distribute capital gains?
Both mutual funds and ETFs are required to distribute capital gains and income to investors at least annually.
For most ETFs, selling after less than a year is taxed as a short-term capital gain. ETFs held for longer than a year are taxed as long-term gains. If you sell an ETF, and buy the same (or a substantially similar) ETF after less than 30 days, you may be subject to the wash sale rule.
Just like mutual funds, ETFs distribute capital gains (usually in December each year) and dividends (monthly or quarterly, depending on the ETF). Even though capital gains for index ETFs are rare, you may face capital gains taxes even if you haven't sold any shares.
Capital gains distributions from mutual funds (and ETFs on occasion) are taxed at the long-term capital gains rate. Comprehensively, ETFs don't often have capital gains distributions, which makes them more tax-efficient than mutual funds.
The structure of an actively managed ETF can enable it to have lower expenses vs. a comparable mutual fund. Tax efficiency. The share creation and redemption process can possibly result in ETFs being more tax-efficient than a comparable mutual fund because the process is done "in-kind," which is not a taxable event.
ETFs are built to avoid the capital gains that result from turnover and redemptions. Investors buy or sell ETF shares on a stock exchange from other investors, not the fund. This avoids the need to raise cash to meet redemptions for small investors.
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.
ETFs and Dividend Taxation
The stocks that are held by ETFs usually pay dividends quarterly or once a year. ETFs holding bonds usually pay interest monthly. If you're investing in an ETF that holds stocks, make sure it pays qualified dividends.
A distribution is the share of income an investor receives from their ETF or managed fund. An ETF is essentially a diversified set of securities and as such, acts as a microcosm of a whole portfolio of investments.
Look for funds that have a low turnover rate. This means that they tend to sell and move assets less frequently than other funds. The longer a mutual fund holds its assets, the less often it will generate sales and distributions. Also, look for funds that tend to reinvest profits rather than issuing distributions.
How do capital gain distributions work on ETFs?
A capital gains distribution is a payment by a mutual fund or an exchange-traded fund (ETF) of a portion of the proceeds from the fund's sales of stocks and other assets from within its portfolio. It is the investor's pro-rata share of the proceeds from the fund's transactions.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
Since these transactions occur between two market participants and not the fund itself, existing shareholders are insulated from others actively buying and selling shares – thus avoiding taxable transactions within the ETF.
| Actively managed ETF | Expense Ratio | One-year Performance* |
|---|---|---|
| Blackrock Large Cap Value ETF (BLCV) | 0.55% | 27.8%** |
| Fidelity Magellan ETF (FMAG) | 0.59% | 40.5% |
| Invesco Active U.S. Real Estate Fund (PSR) | 0.35% | 3.6% |
| JPMorgan Equity Premium Income ETF (JEPI) | 0.35% | 14.9% |
Disadvantages of Active Management
Actively managed funds generally have higher fees and are less tax-efficient than passively managed funds. The investor is paying for the sustained efforts of investment advisers who specialize in active investment, and for the potential for higher returns than the markets as a whole.
ETFs provide investors with low-cost access to diversified holdings across broad markets, sectors, and asset classes. Passive ETFs tend to follow buy-and-hold strategies to try to track a particular benchmark. Active ETFs utilize a portfolio manager's investment strategy to try outperform a benchmark.
Q: How does the wash sale rule work? If you sell a security at a loss and buy the same or a substantially identical security within 30 calendar days before or after the sale, you won't be able to take a loss for that security on your current-year tax return.
Generally, ETFs will have a slight edge from a tax efficiency perspective. ETFs tend to distribute comparatively fewer capital gains to shareholders – these same gains are simply more challenging to manage efficiently from a mutual fund. Overall, VOO and VTI are considered to have the same level of tax efficiency.
- Invest for the Long Term.
- Take Advantage of Tax-Deferred Retirement Plans.
- Use Capital Losses to Offset Gains.
- Watch Your Holding Periods.
- Pick Your Cost Basis.
Both mutual funds and ETFs are required to distribute capital gains and income to investors at least annually. It's important to pay attention to these estimates as there can be instances where the capital gains distributed represent a significant amount relative to the asset value.
How long should you hold ETFs?
Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.
The one time it's okay to choose a single investment
That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market.
Mutual funds have made dividend reinvestment easy but reinvesting dividends earned from exchange-traded funds (ETFs) can be slightly more complicated. Dividend reinvestment can be done manually, by purchasing additional shares with the cash received from dividend payments, or automatically if the ETF allows.
VTI is a total U.S. market fund and holds more than 3,500 stocks. VTI is better diversified and benefits from small and mid-cap stocks that grow into large caps. VOO is less diversified, tracking the performance of the S&P 500 Index. VOO excludes small and mid-cap stocks.
| Symbol | Name | Dividend Yield |
|---|---|---|
| TSL | GraniteShares 1.25x Long Tesla Daily ETF | 100.86% |
| KLIP | KraneShares China Internet and Covered Call Strategy ETF | 59.59% |
| TSLY | YieldMax TSLA Option Income Strategy ETF | 56.71% |
| CONY | YieldMax COIN Option Income Strategy ETF | 53.47% |
