How To Avoid The Tax-Liability Of Short ETFs
December 16, 2008

SAN DIEGO (ETFguide.com) - Just about a week ago Rydex announced unsually large capital gains distributions for some of their short ETFs. Such distributions are very uncommon as ETFs tend to be much more tax efficient than mutual funds.

Here's a sample of preliminary 2008 tax gain distributions reported by various ETF providers so far:

- 119 of 120 PowerShares ETFs declared no 2008 capital gains distributions
- 176 of 178 iShares ETFs declared no 2008 capital gains distributions
- 31 of 33 Claymore ETFs delcared no 2008 capital gains distributions
- 12 of 13 Market Vectors ETFs declared no 2008 capital gains distributions
- All 38 of Vanguard's ETFs declared no 2008 capital gains distributions
- All 9 of State Street's Select Sector SPDRs declared no 2008 capital gains distributions

The large capital gains distributions for Rydex's short ETFs were caused by a number of factors. And put together, these factors created a potentially unfortunate situation for investors with these funds held in a taxable account.

In fairness, it should be said that Rydex announced the distributions in advance (December 5th) in order to give investors a chance to avoid the tax liability by selling their shares before the record date. Rydex is the only inverse ETF provider that has formally announced 2008 distributions to date.

Never miss a beat >> Sign up for the #1 FREE ETF Newsletter

Only shareholders as of December 9th (ex-dividend date) were liable. Shareholders that sold their shares before the close of December 9th or bought shares on December 10th or thereafter completely avoided being liable for any 2008 tax gains.

For shareholders as of the close on December 9th, the following capital gains distributions apply:

While the distributions can pose a significant performance drag it is important to keep in mind that the Rydex Inverse 2x Select Sector SPDR ETF (NYSEarca: REC) did not actually lose 86.61%. The fund's net asset value (NAV) proportionately dropped by this amount and investors will receive cash representing 86.61% of the NAV.

Will ProShares and Direxion distribute 2008 capital gains distributions?

Thus far, ProShares and Direxion have yet to announce capital gains distributions. The best point of reference is last year’s ex-dividend date, which was December 20th for ProShares. Direxion's suite of short ETFs was just launched in November.

It is quite likely that some ProShares and Direxion ETFs will announce capital gains distribution. While the scope of such distributions is unknown as of yet, they are expected to be significantly lower than Rydex's.

How can this happen?

Due to the unique redemption process of ETFs, taxes are usually absorbed by institutional investors who redeem securities of the underlying ETF often to pocket arbitrage profits. Shares with a lower tax basis are redeemed first, leaving the individual investor with little to worry about.

Since underlying securities of inverse ETFs are options, futures contracts and swaps rather than individual stocks, the redemption process does not always work as smoothly. If a short ETF is redeemed, the fund company has to sell some of the underlying options and swaps in order to raise cash.

Never miss a beat >> Sign up for the #1 FREE ETF Newsletter

REC's situation was further complicated by the large spike and subsequent drop of oil prices and energy companies along with a sizeable redemption. Small ETFs tend to get stuck with more tax distributions than larger funds. As of today, REC has less than $5 million under management.

Imagine how two spoons of hot sauce in a cup of soup creates significantly more spice than two spoons in a bowl of soup. The amount of hot sauce is the same in both cases, but the impact is less on the larger base or bowl of soup.

Based on the above reasoning, tax-distributions for popular ProShares such as the ProShares UltraShort Financial (NYSEarca: SKF), ProShares UltraShort Real Estate (NYSEarca: SRS) and ProShares S&P 500 (NYSEarca: SDS) will not nearly be as significant as for REC.

Inverse or short ETFs have given investors the opportunity to benefit from down markets with a simple brokerage account. Shorting the market was previously reserved for sophisticated investors and has been brought from Wall Street to Main Street by creative ETF providers such as Rydex and ProShares.

Short ETFs have been a great tool to hedge against the losses suffered by the S&P 500 (AMEX: SPY) or Dow Jones (AMEX: DIA).

Even though the distributions by Rydex were significant, they could easily have been avoided by selling affected ETFs on or before December 9th. At the very least, Rydex sent out an early alert giving investors a heads up. Whether they paid any attention is anyone's guess.