Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 467

Two index ETF gifts at tax time

Here's a reminder about two gifts for investors just in time for tax reviews and Christmas in July. Index Exchange-Traded Funds (ETFs) are managed funds bought and sold on a listed exchanges such as the ASX and they have tax benefits compared with unlisted and actively-managed funds.

Gift 1: Streaming of capital gains

The 2021/22 financial year ended with negative returns for many asset classes. In periods of such volatility, many investors have exited the funds they were in, waiting for calmer days. Such a strategy comes with the perils of market timing, but in unlisted managed funds, the tax liability for an investor who stays in the fund goes up as other investors leave. ETFs have a mechanism to mitigate this risk.

In unlisted managed funds, if an investor redeems from the fund, they leave behind their share of the tax liabilities on any capital gains that are realised. In an unlisted managed fund these tax liabilities will be attributed to the remaining investors.

This does not happen in an ETF. Investors sell their units on the exchange to other investors, or the market maker. A market maker is someone whose job is to ensure there are units available for investors to buy or sell. In an ETF this doesn’t happen because the withdrawal mechanism is different.

An investor who wants to withdraw from an ETF simply sells their units on ASX where they are purchased by other investors or an ‘Authorised Participant’. Only Authorised Participants may withdraw (redeem) from the ETF. If they do, the capital gains created by the withdrawal can (and will) be passed to the Authorised Participant rather than being left behind for remaining investors. The ETF therefore protects investors from the impact of redemptions by other investors.

Those who have had a bad tax experience with an unlisted managed fund will understand. An ETF won’t hit you with a large taxable distribution the way an unlisted actively managed fund can do due to client redemptions.

This tax efficiency is often an overlooked benefit of investing ETFs.

Gift 2 – Passive management and less trading

Passive ETFs hold a portfolio of shares or other assets that track an index. As a passive ETF’s portfolio is automatically determined by the rules of the index, its portfolio only changes when the index changes. The contrast to this is actively managed funds where the fund manager picks the shares that they think are going to perform the best.

The tax problem with the active management process is that it causes a lot of shares to be sold each year, whereas the index fund process generally does not. The more shares that are sold by the active fund manager in a year, the higher the investor’s capital gains tax liability for that year. This brings forward capital gains. 

To summarise:

  1. ETFs are generally a tax efficient investment vehicle because they minimise exposure to capital gains tax when other investors redeem.
  2. As passive funds, ETFs typically have low turnover and therefore generate lower levels of capital gains tax compared to actively managed funds.

AMIT and TOFA

For more tax details on AMIT (Attributed Managed Investment Trust) and TOFA (Taxation of financial arrangements), see Avoiding tax time dinosaurs.

While AMIT can be used to smooth income payments, the TOFA hedging rules smooth the tax liabilities for investors in a fund that hedges its currency exposure. Without it, currency hedging can lead to tax shocks.

 

Michael Brown is Finance Director at VanEck, a sponsor of Firstlinks. This is general information only and does not take into account any person’s financial objectives, situation or needs.

For more articles and papers from VanEck, click here.

We outline tax advantages in The Tax Advantages of ETFs which can be found on the ETF education page.

 

4 Comments
Chris
July 27, 2022

I can certainly confirm this was the case with a certain unlisted Colonial fund this year. Over 2022 the value of the investment decreased by 30% (including all distributions reinvested), yet still received a taxable distribution of about 30%. So no cash received, loss of 30% capital value and a tax bill. 

Mark Bennett
July 20, 2022

I disagree with the comments in 'gift 1'. It is true that a retail investor may well sell their units to a market maker but market makers do not want to hold many units for much time, hence they will redeem the units via the RE and this will have the same impact as any redemption for a managed funds. Some structures, such as managed accounts, avoid this problem but ETFs whether active or passive do not. In terms of your gift 2, there are a number of actively managed ETFs [or ETMFs if that term is preferred] that have low portfolio turnover and hence distribute small amounts of capital gains, some have carried forward capital losses [often as a result or accepting buy backs rich with franking credits] so perhaps investors should consider both of these factors. If this is of importance to the investor, perhaps consider EIGA which has low turnover and carried forward tax losses.

Michael Brown
July 20, 2022

Thanks for reading my column. ETFs do indeed avoid this problem. When the market maker redeems, the ETF streams to the market maker any capital gains that are realised. So the capital gains tax impact that would otherwise fall on the remaining investors is removed.

It is true that managed accounts also avoid this problem. That said, it is very difficult though to administer portfolios of international equities or bonds through a managed account.

k28945
July 20, 2022

Feels like the tax efficiency must be more complicated than described here. There were come chunky capital gains included in distributions of some of the broad index ETFs for the June quarter. For example, in the case of SYI, 27% of the distribution is made up of franked dividends, and virtually all of the rest – 72% – is capital gains!! Even for the broad index tracker STW, 55% of the distribution is franked dividends, but 37% is capital gains (the rest is rats and mice).

 

Leave a Comment:

RELATED ARTICLES

Indexing tax thresholds to address bracket creep

CPI lowballs the true cost of living

A capital gains tax discount is legitimate but how much?

banner

Most viewed in recent weeks

Vale Graham Hand

It’s with heavy hearts that we announce Firstlinks’ co-founder and former Managing Editor, Graham Hand, has died aged 66. Graham was a legendary figure in the finance industry and here are three tributes to him.

Australian stocks will crush housing over the next decade, one year on

Last year, I wrote an article suggesting returns from ASX stocks would trample those from housing over the next decade. One year later, this is an update on how that forecast is going and what's changed since.

Avoiding wealth transfer pitfalls

Australia is in the early throes of an intergenerational wealth transfer worth an estimated $3.5 trillion. Here's a case study highlighting some of the challenges with transferring wealth between generations.

Taxpayers betrayed by Future Fund debacle

The Future Fund's original purpose was to meet the unfunded liabilities of Commonwealth defined benefit schemes. These liabilities have ballooned to an estimated $290 billion and taxpayers continue to be treated like fools.

Australia’s shameful super gap

ASFA provides a key guide for how much you will need to live on in retirement. Unfortunately it has many deficiencies, and the averages don't tell the full story of the growing gender superannuation gap.

Looking beyond banks for dividend income

The Big Four banks have had an extraordinary run and it’s left income investors with a conundrum: to stick with them even though they now offer relatively low dividend yields and limited growth prospects or to look elsewhere.

Latest Updates

Investment strategies

9 lessons from 2024

Key lessons include expensive stocks can always get more expensive, Bitcoin is our tulip mania, follow the smart money, the young are coming with pitchforks on housing, and the importance of staying invested.

Investment strategies

Time to announce the X-factor for 2024

What is the X-factor - the largely unexpected influence that wasn’t thought about when the year began but came from left field to have powerful effects on investment returns - for 2024? It's time to select the winner.

Shares

Australian shares struggle as 2020s reach halfway point

It’s halfway through the 2020s decade and time to get a scorecheck on the Australian stock market. The picture isn't pretty as Aussie shares are having a below-average decade so far, though history shows that all is not lost.

Shares

Is FOMO overruling investment basics?

Four years ago, we introduced our 'bubbles' chart to show how the market had become concentrated in one type of stock and one view of the future. This looks at what, if anything, has changed, and what it means for investors.

Shares

Is Medibank Private a bargain?

Regulatory tensions have weighed on Medibank's share price though it's unlikely that the government will step in and prop up private hospitals. This creates an opportunity to invest in Australia’s largest health insurer.

Shares

Negative correlations, positive allocations

A nascent theme today is that the inverse correlation between bonds and stocks has returned as inflation and economic growth moderate. This broadens the potential for risk-adjusted returns in multi-asset portfolios.

Retirement

The secret to a good retirement

An Australian anthropologist studying Japanese seniors has come to a counter-intuitive conclusion to what makes for a great retirement: she suggests the seeds may be found in how we approach our working years.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.