ETF Tax Shocker: Huge Payout For Rydex Inverse Funds
December 10, 2008
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It is not often that the share price of an exchange-traded fund falls 87% overnight.
But that's what happened on Dec. 10 to the Rydex Inverse 2X S&P Select Sector Energy ETF (NYSEArca: REC), an ETF that aims to deliver -200% of the return of the S&P Select Sector Energy Index. The fund, which closed at $100.28/share on Dec. 9, opened on Dec. 10 at $12.61/share.
The reason? A record capital gains distribution.
Rydex announced that any shareholder holding REC as of the close of trading on Dec. 9 would receive a short-term capital gains payout worth 86.61% of the fund's net asset value, and the fund's share price dropped accordingly.
Importantly, these shareholders don't lose 86% of their investment; rather, they will receive a check from Rydex for this amount. The problem, though, is that this payout is fully taxable as ordinary income. That means that a shareholder who held $10,000 of REC on Dec. 9 will have to pay income taxes on an extra $8,600 this year. (Had REC made long-term gains distributions, those gains would have been taxed at the more favorable 15% long-term capital gains tax rate.)
Rydex Inverse Funds Hit
REC is not the only Rydex fund hit with significant distributions this year. Each of the company's seven inverse ETFs paid out large amounts of cap gains.
Shareholders and financial advisors had a clear opportunity to avoid these gains. Rydex initially announced estimated payouts for each of these funds on Dec. 5, and made clear that Dec. 10 would be the ex-dividend date. It also made it clear that shareholders had until Dec. 9 to trade out of the funds and avoid the capital gains hit.
Capital gains distributions are distinctly binary: Any shareholder who held one of these funds at the close of trading on Dec. 9 will receive the full distribution, even if they bought the fund just one day prior; conversely, any shareholder who sold the fund prior to the close of trading on Dec. 9 will avoid the capital gains payout altogether.
If investors or advisors held a fund like REC in a taxable account, they should have sold out of the fund to avoid the cap gains hit.
Capital Gains In ETFs?
An 86% capital gains distribution is off the charts for any mutual fund, but it is all the more surprising for an ETF. The ETF industry has built its reputation on being more tax efficient than traditional mutual funds. ETF companies like Barclays Global Investors, State Street Global Advisors and PowerShares have all announced minimal capital gains payouts this year, for instance. To take one example, SSgA is making distributions on just three of its 80 ETFs, and the payouts are minimal: less than 1% of fund assets.
The reason most ETFs can avoid the tax man is that they use the "creation/redemption" facility to get rid of holdings that might incur capital gains. For instance, an ETF like the S&P 500 SPDRs (NYSEArca: SPY) will hold all of the stocks in the S&P 500. If those shares rise in value, they will have an accumulated capital gain; were the fund to sell them, it would incur those gains and be forced to distribute them to shareholders.
But with ETFs, there are professional market makers who periodically "redeem" shares of the fund. To do this, they buy up a certain number of ETF shares (typically 50,000) and then deliver those to the ETF provider in exchange for the commensurate value in the ETFs' core holdings; to use SPY as an example, the market maker would receive shares in each of the S&P 500 stocks. It's called an "in-kind" redemption. The market maker may do this because the value of the ETF is lower than the value of the underlying shares, and they hope to make a profit by arb-ing the difference.
This redemption process gives the ETF company the opportunity to get rid of its shares with a low tax basis. They simply deliver those shares to the market maker, and keep the shares that are more tax-friendly. As a result, most ETFs dodge the tax bullet.