Investors in one of Main Street's hottest investment products may get an unexpected parcel this holiday season -- a tax bill.
Exchange-traded funds, which are baskets of securities that follow an asset class or sector, have been a hit for many investors, with brokers proclaiming a host of tax advantages. But while many of those benefits are still intact, investing experts now expect some ETFs that track bonds to generate tax bills this year, largely due to the wild swings in the market.
"Investors could be caught off guard," said Jim Lowell, chief investment officer of Adviser Investments in Newton, Mass., which manages $2.3 billion in ETFs and mutual funds.
Bond ETFs join other breeds of exchange-traded funds that have lately turned out to be less tax-efficient than many once thought. For example, experts say that ETFs that track publicly traded partnerships and commodities might have hidden tax traps, too, requiring investors to prepare multistate tax filings or pay up to a 28% rate for gains on commodities the Internal Revenue Service deems "collectibles."
Now, many advisers have turned their attention to relatively safe bond ETFs. And these funds have been a hot subcategory, attracting $32 billion in assets so far this year, up from $26 billion last year, with many investors assuming these funds would be more stable than ETFs that track stocks.
That assumption hasn't quite worked out. Investing pros say this year's extreme market volatility contributed to big gains for many bonds, especially Treasurys. When ETF fund managers have to sell those bonds to rebalance their portfolios, that can trigger capital gains.
Earlier this month, BlackRock's iShares announced that its $14 billion iShares Barclays Aggregate Bond Fund (AGG)
For their part, the fund companies say these investments still are good bets. "The focus should be on the after-tax return," said Joel Dickson, senior investment strategist at Vanguard. Vanguard's Extended Duration Treasury ETF returned 29% after taxes through Sept. 30.
Indeed, most experts say ETFs are still very tax-efficient overall. Last year, less than 10% of all ETFs distributed capital gains, according to fund tracker Morningstar, and BlackRock noted that 99% of its iShares ETFs will likely not distribute capital gains this year.
Still, some financial advisers watch their clients' ETF portfolios closely for capital gains. Mitch Reiner, an adviser in Atlanta, sold clients out of some bond ETFs last year before their capital gains were realized. While the gains might not have been that big, Mr. Reiner said the hassle was: "They caused us to do a lot of extra work."
Others pros say they are sidestepping the tax issue by telling their clients to buy bond ETFs solely in their individual retirement accounts and 401(k) plans, where the dividends and capital gains aren't taxed.