ETFs and tax explained: why 2021 was a capital gains headache for investors

Exchange-traded funds. Simple right? Accessible, diversified, transparent. That's all true. But some investors got a nasty shock on 30 June as their funds plummeted in value. A handful of top performing global equity ETFs had big distributions to pay out, leaving investors with unexpectedly large capital gains. Net asset values fell accordingly.

iShares S&P 500 AUD Hedged ETF (IHVV) fell the hardest, down 17 per cent. ETFS FANG+ ETF (FANG) fell 9 per cent while Vanguard MSCI Intl (Hdg) ETF (VGAD) fell 6 per cent.

Value iShares S&P 500 (AUD Hedged) ETF (IHVV) 

28/06/2021 - 02/07/2021

Source: Morningstar

While ETFs are "simpler" investment vehicles, there are still nuances that come with pooling your money with others. The phrase 'do your homework' is trite but true.

In this article, we'll delve into how ETFs manage and distribute capital gains and why investors received outsized distributions in FY2021.

ETFs and distributions

ETFs are classified by the ATO as managed investment trusts (MITs). They are a basket of securities rolled-up into one security that trades like a stock on the exchange. Unlike companies and super funds, ETFs (generally) do not pay their own tax, instead of passing on the liability to investors.

Income (including realised capital gains when the underlying assets are sold and dividends) is divided among unit holders based on how many units they hold at distribution time. Unit holders must then include their share of this income in their own tax return in the year it was earned.

Distributions are paid to all unit holders equally, whether the investor was in the fund one day or one year. Immediately after a distribution is declared, the unit price of the fund will usually fall by the amount of the distribution, because the distribution reduces the fund’s assets.

A handful of ETFs experienced 'extreme' price movements around their ex-dividend date

Source: Morningstar

How ETFs calculate capital gains is complex as they are structured products, not ordinary shares. To determine annual taxes, ETFs "act" as if investors held the underlying investments themselves. This is known as 'flow through', explains VanEck director of operations and finance Michael Brown.

"The simplest thing to do would be to say an investor received $X in income, they put $X into their tax return and pay $X at their marginal tax rate," he says. "However, this wouldn't produce an equitable outcome. Investors couldn't receive capital gains tax discounts etc. So, we have to go through this complexity of taxing the investors as though they held the investments themselves."

"This produces some really long and complex annual tax return statements for investors."

Source: Vanguard, Sharesight

A key element of the flow-through system is managing the frequency and level of distributions. With ordinary shares, a company board can elect to hold back profits in a good year, and dip into past profits to make up for any shortfall.

ETFs historically couldn't "smooth" their tax liability. Take Vanguard's Australian Shares ETF (VAS) for example. The fund invests mostly in ASX shares, whose companies pay dividends, some annual, some half-yearly, and are subject to franking credits. The benchmark, S&P/ASX 300, rebalances semi-annually, moving individual securities in and out of the portfolio and forcing the fund to realise capital gains.

ETFs are highly tax efficient. Compared to managed funds, they tend to have lower turnover and pay out fewer capital gains. However, in times of extreme volatility, distributions can jump around for certain asset classes.

Payouts from these ETFs were elevated in FY2021

Source: Morningstar, Company websites

Smoothing income – AMIT and ToFa

In 2016, the Australian government introduced the Attribution Managed Investment Trust (AMIT) regime. Managers who opt into the AMIT regime can distribute cash however they see fit. Previously, cash distributions had to match the taxable income of the fund each year, but under AMIT, the taxable income and the cash distributed can differ. Theoretically, this should allow funds to smooth out cash distributions from year to year or even to target a consistent distribution level. However, VanEck's Brown says very few funds are actively implementing these changes.

"There's a sense of inertia here," he says. "Funds have been doing it the same way for years and years. It's a big deal to suddenly uproot everything you've been doing – moving from something very mechanical to a regime where judgement is required."

Former Morningstar fund analyst Alex Prineas says it is up to the fund manager to determine what is fair and reasonable, after considering factors like the mix of investors in the fund and the fund’s objectives.

"Our discussions with fund managers suggest that many of them are still preparing for the AMIT regime, and even after they have opted into AMIT, it will be a while before most funds are able to take full advantage of it," he wrote in a 2018 article.

Another older change called Taxation of Financial Arrangements, known affectionately by the boffins as ‘ToFA’ (pronounced “tofu”), radically rewrote how fixed income and derivatives were taxed. Managers who make a "hedging election" under TOFA can protect a fund’s income stream by deferring currency hedging gains or losses. This was an attempt to recognise the role hedging played in a portfolio. As Brown explains:

"Passive funds tend to hold their equities for the long term. You've got the underlying securities that are going to create capital gains, at some distant point in the future.

"To hedge them at a low cost, the way to do it is short term FX forward contracts that you roll every month. The hedging contracts are very short term, and the things they're hedging are held long term. So, you get a tax mismatch.

"The ToFA recognised that when a hedging transaction and an underlying transaction are both occurring, they can offset each other."

Issuers have similarly been reluctant to implement these changes, Brown says.

"When you set these things up, there are several hurdles to clear, and complex processes to put it place. I've worked in big companies and I understand they see these things as hard to do. Turning around a big ship – it's hard. Smaller firms definitely have an advantage."

Why is this year different from all other years?

While these issues have been bubbling away for years, investors took notice on 30 June when several global equity funds distributed bumper dividends. So, what happened? The answer depends largely on the fund type and what it holds.

For traditional broadly diversified, market-cap weighted funds, Brown attributes payouts to the extreme market volatility in the initial covid-19 outbreak. This caused underlying indexes to change more than they ordinarily would and as such, more stocks removed and more gains realised at rebalancing. Many changes had built up over the years and this particularly affected older funds.

"In the early years, the capital gains rules worked in your advantage because you can push things into the future," Brown says. "But the time comes where you can't push it any further and it comes homes to roost. Older funds built up big liabilities."

Highly concentrated funds were particularly impacted. Take ETF Securities' FANG+ ETF which jumped from 12 cent distribution in its first year in inception to 217 cents this year. The fund, which launched in early 2020, holds just 10 stocks offering exposure to "next generation technology". The fund rebalanced by selling down some positions during the period and passing gains onto investors.

"The question is what proportion of the index changed," Brown says. "If you're concentrated, twenty or so stocks, it only takes one or two changes to have an impact. If you've got 300 stocks and one or two leave, particularly smaller holdings, that's largely immaterial."

Risks in currency hedging

For hedged funds, the story is different again. These funds use hedging to protect against adverse currency moves. Brown says both volatility in the Australian dollar against the US dollar in the post-covid period, and the relative strength of the Australian dollar helped produce excellent returns. The Vanguard MSCI global hedged ETF (VGAD) gained close to 36 per cent. But on June 30, the fund fell 7 per cent as Vanguard was forced to distribute capital gains to investors. Distributions jumped from zero in June 2020 to 650 cents per unit a year later. Vanguard has integrated both AMIT and ToFa to allow for smoothing distributions but is unable to integrate ToFa into its hedged global equity products. A company spokesperson says the regime is too onerous in its current form. 

Morningstar's Prineas says "hedge accounting" is complicated and costly, and that many fund managers have not made a TOFA hedging election.

"Hedge accounting requires fund managers to account for each hedge contract and link it to a particular asset in the fund," he says.

"This was easy for funds that get their exposure by cross-investing into another vehicle–for example, some iShares bond ETFs get their exposure by investing directly into an overseas ETF, which means they need to account for only one fund asset (even if that asset has many underlying exposures). Whereas for funds that hold individual securities directly, it can become incredibly complicated."

Investors in iShares Core MSCI World All Cap AUDH ETF (IHWL) were hit with a double whammy. The fund is hedged, and currency gains were a large contributor. IHWL gained almost 40 per cent (total return) in FY2021, paying out distributions of 512 cents. But the fund also changed to an ESG-friendly benchmark, rebranding as iShares Core MSCI World ex Australia ESG Leaders (AUD Hedged) ETF. To transition, the fund realised net capital gains it received from the sale of its previous investments – four iShares equity ETFs – and purchased a new portfolio of securities.

Brown explains that a benchmark change could create a sizeable taxation event for investors. "Changing a benchmark brings forward capital gains tax liabilities that would otherwise be off in the future," he says. "A responsibility entity would need strong reasons to do it.”

Value, distribution history | IHWL

Star = distribution date

Source: iShares, Morningstar

Asked whether ETF issuers should have done more to warn or explain to investors about the large distributions, Brown believes the best funds should be working behind the scenes to smooth distributions and avoid 'crunchy' gains.

"It's good to explain this stuff and the odd investor does want to dig into the details. But the truth is most investors don't care," he says.

"They don't understand it and they don't want to understand it. They're paying you a fee to do it for them. The responsible entities are responsible for running the fund the best they can and that includes tax. If there are choices to be made in the tax act, you have to make the best choices that are in the best interest of investors."

The impact of these tax measures is complex. Distributions don't represent income, and are unlikely to be consistent, so investors shouldn't count on them. For information on specific funds, Morningstar analysts recommend investors contact their fund manager, adviser or tax professional as the picture is evolving over time as fund managers develop their AMIT and TOFA capabilities. 

Editor's Note: This article incorrectly stated that Vanguard did not integrate AMIT or ToFa to allow for smoothing distributions. It has integrated both regimes but not for its hedged global equity products.