The Tax Consequences of ETF Portfolio Turnover & Capital Gains
An exchange-traded fund is a way for investors to get access to a particular investment style or sector in one investment. Rather than having to buy all of the individual stocks in the Standard & Poor's 500 Index, for example, you can buy the S&P ETF, which attempts to mimic the return of the S&P index. Portfolio turnover and capital gains can result in tax consequences for individual investors.
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ETF Structure
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An ETF is a fund that trades like a stock on a public exchange. Within the ETF, a portfolio manager buys or sells investments that are appropriate based on the ETF's stated investment objective. For example, if you buy an ETF that intends to reflect the performance of the Dow Jones Industrial Average, the portfolio manager for that ETF will purchase stocks that mirror that average as closely as possible. The ETF passes through any income or capital gains that it receives to shareholders after subtracting any expenses necessary to the operation of the fund. If an ETF has a high portfolio turnover, that could affect the total investment performance of the ETF due to the higher costs involved.
Portfolio Turnover
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Portfolio turnover refers to the amount of buying and selling that a manager does within an ETF. The higher the portfolio turnover, the more active the manager is. For example, if you buy an ETF that holds $10 million in investments and the manager buys and sells $10 million worth of stock within the ETF, the portfolio turnover is 100 percent. The more a manager trades, the more money is taken out of the fund to pay for transaction costs. A manager with a high portfolio turnover generally has higher capital gains as well, which could translate into higher tax costs for investors.
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Capital Gains
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When an ETF manager sells a stock at a profit, he generates a capital gain for the fund. At the end of the year, the ETF must make a distribution equal to the amount of capital gains generated for the year. As a shareholder, if you receive a capital gains distribution, you must pay capital gains tax on it. An active ETF manager with a high portfolio turnover is more likely to generate capital gains, so the two are often interrelated.
Buying and Selling an ETF
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The biggest tax consequence from owning an ETF may come from the manner in which you trade it. As with any other type of investment, when you buy an ETF you establish your cost basis, which is the total amount you pay for the ETF. When you later sell the ETF, the difference between your sales proceeds and your cost basis is your gain or loss. If you sell the ETF at a higher price than what you paid, you will have a capital gain on which you must pay tax. This is in addition to any capital gains distribution that the ETF also may have made.
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