Understanding investment types

A primer on ETF capital gains distributions

ETFs are highly tax-efficient, but they can occasionally distribute capital gains.
6 minute read
November 15, 2021
Understanding investment types
Capital gains
Financial terms

Millions of investors rely on exchange-traded funds to help them achieve their most important financial goals. ETFs have been widely adopted by investors for a number of reasons—including low costs, broad diversification, low tracking error, and easy accessibility. Another essential feature for many ETF investors is tax efficiency.

A few key factors contribute to that tax efficiency

First, many ETFs track market-capitalization-weighted indexes. Effective tracking of such indexes typically can be achieved with minimal portfolio turnover—especially for equity indexes—and low-turnover strategies are inherently tax-efficient.

Furthermore, tax efficiency is built into the ETF ecosystem. Because ETFs trade on exchanges much like the way individual stocks do, the vast majority of trading in ETFs takes place between investors on the secondary market, with no impact on the ETFs’ underlying securities.

A much smaller share of ETF trading occurs on the primary market, where ETFs create or redeem shares through transactions with financial institutions known as authorized participants. For most primary market transactions, ETF shares are exchanged for a basket of securities rather than cash. Such “in-kind” transactions are not considered taxable events and thus also contribute to ETFs’ tax efficiency.

Draft legislation unveiled in the Senate proposes changes to the tax treatment of in-kind transactions. Vanguard opposes these changes and believes that the current tax treatment of in-kind transactions is in investors’ best interest. We continuously work with policymakers to advocate for policies that give investors the best chance for investment success.

ETFs are tax-efficient but not tax-free

Investors should keep in mind that, although ETFs are highly tax-efficient, they may occasionally distribute capital gains. The primary goal of index-based ETFs is to track the target index as closely as possible. Maintaining tax efficiency is another important goal for Vanguard’s portfolio managers, but that’s ultimately one of multiple secondary objectives—which include managing transaction costs and adding benchmark-relative value—that Vanguard balances in the best interest of our diverse shareholder base.

Although the ETF creation/redemption process described earlier improves tax efficiency, realized capital gains distributions remain possible. Redeeming ETF shares in kind can minimize the ETFs’ need to sell securities at a taxable gain, thereby reducing the need for realized gains to be distributed to ETF shareholders. But this process does not eliminate capital gains for shareholders, who will generally realize a taxable gain or a loss when they sell their ETF shares. Furthermore, ETFs may engage in taxable transactions to buy and sell securities, such as when a target index is rebalanced and certain securities are added to or removed from it.

Although several factors can contribute to ETFs’ realization of capital gains, perhaps the most important is the consistent appreciation of an ETF’s holdings over an extended period. Global equities have generally enjoyed significant gains, with only brief interruptions, for more than a decade. As a result, many ETFs hold securities with unrealized capital gains that can become realized through the normal course of portfolio operations.

What investors should know

For most investors, ETF capital gains distributions are simply a marginal reduction in the control that investors have over timing the realization of gains. Capital gains distributions by an ETF bring forward the payment of taxes that would otherwise be embedded in the ETF’s net asset value and therefore might be realized when the shares are eventually sold. Put another way, when an ETF distributes capital gains to its shareholders, taxes are paid on those gains now rather than at a future time when an investor sells the ETF shares at a gain.

Keep in mind that capital gains distributions generally have no impact on an ETF’s performance. Once the capital gains are distributed, the price of the ETF is generally reduced by the amount of the distribution. Note, too, that investors in tax-advantaged accounts such as IRAs and retirement plans are generally unaffected by capital gains distributions.

A commitment to transparency

Vanguard provides transparent and timely estimates of capital gains for all our mutual funds and ETFs. Estimated realized and unrealized gains for Vanguard mutual funds and ETFs are published and updated monthly on our website, and clients can expect to see an estimate of annual gains distributions published on the website each year in late November.

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For more information about Vanguard funds or Vanguard ETFs, obtain a prospectus (or summary prospectus, if available) or call 800-523-1036 to request one. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

All investing is subject to risk, including possible loss of principal.