ISHARES MIGHT BE

the king of exchange-traded funds, but some of the ETF family's offerings are struggling to reign supreme in the realm of tax efficiency.

"There are two aspects that drive tax efficiency in ETFs: capital gains and dividends," says John Demming, a spokesman for Vanguard Group. "Capital gains are important, but we feel investors should look beyond capital gains and take income into consideration when evaluating an investment." Vanguard, the company best known for its low-cost mutual funds, offers 26 ETFs.

Tax efficiency is often cited as an advantage of ETFs over mutual funds, mostly because of issues related to capital gains. Mutual funds usually sell shares to meet the cash requirements of redemptions, which leads to taxable events. The tax burdens of these capital gains are distributed annually among shareholders of mutual funds. ETFs are governed by different redemption rules for a detailed explanation see the July 19 ETF Focus, "Taxing Questions About ETFs" so the capital-gains bite is minimized.

ETF investors still pay taxes on dividend income, however, and that's where iShares, the ETF family owned by Barclays Global Investors, or BGI, the U.S. unit of British banking giant Barclays, may be falling short. Vanguard claims its ETFs can be more tax efficient than iShares' because it places more emphasis on making sure 100% of the dividends it pays out qualify for the lowest tax rate.

In 2003, Congress passed legislation reducing the tax rate on certain kinds of dividend income to 15%. Dividend income that meets the criteria is called qualified dividend income, or QDI. Unqualified dividends are taxed at an investor's regular rate, which can run as high as 35%. Because of the significant tax advantage, most ETF issuers strive to achieve 100% QDI.

"QDI is very important," says Tom Roseen, a senior research analyst at fund research company Lipper. "The difference between a 35% tax rate and a 15% tax rate is huge."

However, many iShares ETFs have fallen short of the 100% mark, some by as much as 19 percentage points. BGI offers 114 ETFs.

"The iShares funds are managed for tax efficiency. The fund complex has not distributed any capital gains for the last five years," says Lance Berg, a spokesman for BGI. "QDI, which is one component of tax efficiency, is a focus of iShares, but this comes out to pennies on the dollar. We believe investors should look at the total cost of a fund when making investment decisions."

Not all income qualifies for the 15% tax rate. Interest earned on bonds and money-market funds is excluded, as are dividends paid out by real-estate investment trusts, or REITs, and most foreign companies. There's also a minimum holding period to qualify. Both the ETF and the investor must hold the dividend-paying stocks for at least 61 continuous days during the 121-day period beginning 60 days before the ex-dividend date and 60 days after. This prevents short-term traders from benefiting from the tax break.

According to Vanguard, iShares S&P 500 Index fund posted QDI of just 93.6% in 2003, 82.6% in 2004 and 64.2% in 2005. IShares doesn't dispute the numbers for 2003 and 2004, but it says the vendor calculating the number last year made an error. QDI for 2005 was restated to 100%.

Meanwhile, during 2003 and 2004 the iShares S&P 500 Growth fund, the iShares Russell 1000 Growth fund, the iShares S&P 500 Value Index and the iShares Russell 1000 Value Index fund posted QDI ranging from 81.0% to 99.6%. Vanguard says its comparable funds all posted 100% QDI. State Street Global says its popular SPDR Trust, Diamonds Trust and eight of its Select Sector SPDR branded ETFs, not including financials, post 100% QDI.

"Barclays isn't doing anything wrong, it just wasn't doing it well," says Dan Culloton, the lead ETF analyst at fund research firm Morningstar. "It is getting better, but it does point to the fact that execution matters. This shows that paying attention to the little details adds value over time."

BGI defended iShares. It said ETFs such as the iShares Dow Jones Select Dividend Index fund grew so fast that much of the cash inflows weren't held long enough to qualify. Others opted for the capital-gains potential of REITs or foreign stocks, which both give off unqualified dividends. However, iShares has options available to manage QDI of which it might not be taking full advantage. For example, unqualified dividend income can be used to pay down an ETF's expense ratio rather than be distributed to shareholders. With this safety valve available, 100% QDI should be possible for most iShares ETFs.

"It's not paying attention to the things that matter," says Gary Gastineau, managing director of ETF Consultants, a consulting firm in Summit, N.J. "Most firms have done a good job of it, but BGI has not."

Excluding ETFs with the majority of their holdings in foreign stocks or REITs, just 16% of BGI's ETFs posted 100% QDI in 2005. Meanwhile, the amount of funds posting 100% QDI at Vanguard and State Street was 74% and 57%, respectively. So, now that the issue is on the table, how does BGI plan to address it this year?

"QDI has definitely been a conversation at iShares," says BGI spokesman Berg. "We've focused on this issue, and it's something we're looking at on behalf of shareholders. Where we can make improvements, we will make those improvements. But it's hard to predict what the numbers will be this year."

Both BGI and State Street declined to give year-to-date numbers. So far this year, Vanguard said 77% of its ETFs post 100% QDI. Meanwhile, PowerShares, one of the fastest-growing ETF firms, says through the middle of the year all of its Dividend Achiever branded ETFs have achieved 100% QDI.