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Posted by on Dec 17, 2013 in Investment Perspective

That Time of Year

That Time of Year

Kyle Bechler, Structured Portfolio Analyst for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD), discusses year-end tax concerns that ETFs can inherently avoid.

This is the time of year when mutual fund investors receive word of capital gains distributions, and this year those distributions are proving to be significant (see a recent article on the subject).  To be sure, this news comes following a year of very good performance for equity markets, so investors can certainly take solace in nice total returns that 2013 has provided.  Unfortunately capital gains distributions mean higher taxes immediately, yet this isn’t your only option.  This leads us to one of the key advantages that the ETF vehicle offers relative to the mutual fund.  The in-kind creation/redemption process for exchange traded funds allows ETF managers to essentially unload securities that have seen gains without creating a taxable event inside the fund.  The net result for investors?  Taxes on capital gain distributions are paid according to the investor’s own timeframe, that is, when he/she decides to exit the fund.

In a strong performance year like 2013, even a large capital gain distribution isn’t the end of the world.  However the real pain comes in a year when investors rush for the exits and mutual funds are hit with large redemptions.  In this scenario, a mutual fund might see flat or even negative performance, while still being forced to sell certain assets at a gain to meet redemption demands.  Investors left at the end of the year could experience both poor performance and a tax bill.  Fortunately, ETFs avoid this trap.

One other point to note is that the ETF space is no longer simply a place for passive, index-based strategies.  As consistent proponents for active management, we certainly understand the desire to invest with a fund manager who has a proven track record and dynamic approach to managing money.  Luckily, a handful of actively managed ETFs are beginning to gain traction and offer investors access to both a tax-efficient fund and an experienced management team in the same product.