Exchange-Traded Funds Are Tax-Efficient, but Not Tax-Perfect

Last week, a press release announced that the iShares MSCI index funds are expected to pay cash dividends to shareholders at the end of August.

Wait a minute. These and other exchange-traded funds, or ETFs, are supposed to be tax-efficient. Right?

Right. But ETFs can distribute dividends and capital gains just like regular mutual funds.

If you own an exchange-traded fund or two, you should at least be on the lookout for these distributions, particularly if you own sector- or style-specific funds. Don't believe the myth that ETFs can't make taxable distributions. They can and do.

Unlike traditional mutual funds, the shares of exchange-traded funds are priced throughout the trading day and trade like stocks. (Almost all conventional funds are priced once a day at the close of trading.)

This frequent pricing and their lower costs have made ETFs an appealing alternative to index funds. Standard & Poor's Depositary Receipts (SPY Quote), or Spiders, which track the S&P 500 index, currently command more than $21 billion in assets.

You can obviously do some things with ETFs that you can't do with conventional mutual funds. Still, you cannot escape distributions.

ETFs, like the Spiders or the newer iShares from Barclays Global Investors, are required to pass along all net realized capital gains and dividends to shareholders -- just like regular old mutual funds.

An ETF, like any mutual fund, would have dividends if it owns a stock that pays a dividend.

The underlying expenses on an ETF are deducted from the dividends. Whatever doesn't get taken for fees gets passed along to you, and those dividends are taxable, unless you own the ETF in a retirement account. For a portfolio like the Spider, you'll probably receive some dividends. The S&P 500, right now, has a dividend yield of about 1.1%. Conversely, a technology-heavy portfolio like the Nasdaq 100 Tracking Stock (QQQ Quote) probably won't pay dividends because most of the stocks it owns don't. (Dividends might be paid quarterly or semiannually, depending on the ETF.)

Exchange-traded funds also are designed to reduce the amount of capital gains they distribute to shareholders each year.

In general, ETFs should make fewer capital-gains distributions than regular index mutual funds because their underlying portfolios aren't as affected by the buying and selling of fund shares by investors. Most investors will simply buy and sell existing shares of the funds among one another, which doesn't hit the actual holdings of the underlying portfolio.

Also, exchange-traded funds can redeem shares in kind -- that is, with actual securities -- rather than by selling securities. It's the sale of securities that have increased in value that can trigger capital-gains distributions. In ETFs, low-cost-basis stock -- shares bought at a very low price that have since appreciated -- also can be handed off to large investors. That allows an ETF to unload the shares of stock in the portfolio that carry big potential tax liabilities.

This process enables ETFs to avoid realizing and distributing capital gains in many cases. The S&P 500 Spider has distributed only 9 cents in capital gains since its launch in 1993, according to the American Stock Exchange's Web site.

But some ETFs are less adept at sidestepping capital gains.

ETFs, like conventional index funds, can be forced to sell securities when the indices that they track add or subtract names. When an index changes, the ETF has to change right along with it.

The MidCap Spider (MDY Quote), which tracks the S&P MidCap 400 index, is a good example.

Last December, the MidCap Spider made a capital-gains distribution of $2 a share, which represented more than 2.5% of its share price at the time.

The cause: America Online(AOL Quote) moved out of the S&P MidCap 400 index and into the 500 in late 1998, which forced the MidCap Spider to sell AOL and realize some gains. In this case, the fund was forced to sell a stock that had appreciated considerably.

With funds that track large-cap indices such as the S&P 500 or the Wilshire 5000, changes to the underlying indices are less of a problem. A stock with fantastic returns won't get kicked out of the index for being too big. Not so with funds that track mid- or small-cap indices that could be regularly forced to sell stocks as they appreciate and leave the underlying index. You'll see the same thing happen with value index funds.

This doesn't mean you'll wind up paying loads in taxes when you own an exchange-traded index fund. But you could owe something.