Understanding Taxable Distributions

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Traditional ETFs are generally tax efficient because the in-kind creation and redemption mechanism limits portfolio turnover.

Conversely, leveraged ETFs have extremely high portfolio turnover as they rebalance portfolios daily in response to market movements and do not experience a significant level of in-kind creation or redemption transactions. As a consequence, leveraged ETFs are generally not tax efficient, at least by the standards of traditional ETFs.

Distributions are generally not good for long-term investors in taxable accounts because such investors seek to (a) delay recognition of gains to allow such gains to compound through time (before paying taxes on the gains) and (b) benefit from the lower tax rate on long-term capital gains. Market commentators seem to look at distributions from the perspective of the long-term investor and therefore view distributions negatively.

Long-term investors are not appropriate users of leveraged index ETFs. Dynamic asset allocators and traders, however, are appropriate users and they do not have the same sensitivity to distributions as long-term investors. Traders generally do not seek to delay recognition of gains (or deferral or taxes) and, as a consequence, generate short-term capital gains, which are taxed as ordinary income. As a consequence, a trader will be negatively impacted from a tax perspective by a distribution only if the distribution exceeds the amount of the trader’s short-term capital gains in the current calendar year.