EDV to pay 3% dividend (in article about bond ETFs and taxes)

[murphy_p_t]

His take on Vanguard Extended Duration Treasury ETF EDV, which will distribute capital gains equal to about 3% of its value: “If anyone is holding that in a taxable account they are crazy to begin with.”?

http://www.marketwatch.com/story/tax-su ... 2012-11-30

[murphy_p_t]

An implication of  this article seems to be to hold bonds directly (rather than TLT, EDV) if you are in taxable account.

[MediumTex]

An implication of  this article seems to be to hold bonds directly (rather than TLT, EDV) if you are in taxable account.

I don't see the difference. If you have a ladder of LTT, and sell when there are X years remaining until maturity to replace with a new bond with a longer maturity, and if rates have been dropping as they have been this year, you will have a capital gain on the individual bond just like the ETF does.

EDV could also have large distributions from mass redemption of shares.

I think it was 2009 when EDV made a 12% or so end of year distribution that was explained by lots of people getting out of the fund.  That would have been an ugly surprise for a taxable share owner who was anticipating a similar experience to owning individual bonds.

[jimbojones]

This is another example of a risk associated with mutual funds vs outright stock or bond ownership.  You lose the ability to time your cash flows.  I'm guessing a lot of funds will be increasing distributions right now to use the 2012 capital gains and dividend tax rates before they increase in 2013.  Unfortunately, not every investor is going to want to recognize those gains now. 

[AdamA]

EDV could also have large distributions from mass redemption of shares.

Why does this happen?  ie, why do redemption of shares cause large distributions?

[rickb]

EDV could also have large distributions from mass redemption of shares.

Why does this happen?  ie, why do redemption of shares cause large distributions?

In response to mass redemption of shares the fund has no choice but to sell bonds, realizing capital gains which turn into distributions.

[Tortoise]

I'm still not quite sure I understand how this works. Let's consider the simpler case of a mutual fund before we consider an ETF. If there is a net redemption of shares within the fund, I understand that the fund will typically have to sell some of the underlying asset in order to convert the redeemed shares into cash.

But shouldn't it just be the shareholders redeeming their shares who receive all proceeds of the asset sales (including capital gains)? They're the ones converting their shares into cash, so they're the ones who should actually be receiving capital gains. Why would a shareholder who does nothing have to receive any capital gains?

I'm sure there's a good, simple explanation--I just haven't heard it yet. The reason why net redemption of shares translates into capital gains distributions for all shareholders rather than only the redeeming shareholders is not at all self-evident to me.

[AdamA]

The explanation is simple, but it may not be good spending on your perception. The way mutual funds and ETFs work, according to securities law, is that any capital gains the fund itself incurs internally are passed through to all shareholders on a pro rata basis. Each shareholder pays capital gains on the appreciation of their personal quantity of shares only when they are sold.

Why?

[TripleB]

The explanation is simple, but it may not be good spending on your perception. The way mutual funds and ETFs work, according to securities law, is that any capital gains the fund itself incurs internally are passed through to all shareholders on a pro rata basis. Each shareholder pays capital gains on the appreciation of their personal quantity of shares only when they are sold.

Why?

Not sure if you're thrown off by the minor typo, he probably meant "depending on your perception."

With regards to why the law is set up this way, it's because the government wants to tax you as often as possible to maximize their revenue. Boondogles aren't cheap.

[rickb]

Maybe we should work through a hypothetical example (fund, not ETF, although ETF will be similar).

Over 5 years 10,000 people each buy $100 of our fund.  The amount they pay per share varies depending on exactly when they bought.  The fund (over 5 years) invests $1M in whatever securities the fund is set up to buy.  To make things simple lets assume the underlying assets have simply gone up all this time and the only transactions the fund has made is additional purchases.

Now, 5 years later, the fund has considerably appreciated and 2,000 of the 10,000 shareholders cash out.  The fund now has to sell some of the (appreciated) securities to generate the cash to pay the folks who are cashing out.  The securities the fund sells are not necessarily (and generally won't be) the same securities the fund bought when each of the people cashing out originally bought in.

Anyone cashing out pays capital gains taxes on the difference between what they originally paid and what they got when they cashed out - although the cost basis is computed as the original price PLUS any capital gains distributions received in the interim (0 in our hypothetical example).

The fund, since it has now sold assets at a gain, has to distribute the gains on whatever it has sold to the (remaining) shareholders.  The IRS doesn't care whether this gain is due to selling securities to cover redemptions, or selling securities to buy other securities - if the fund buys something for $X and later sells it for $Y (Y>X) the difference is a capital gain and this gain must be distributed to the shareholders.  The distribution has two effects - 1) it reduces the per share cost of the fund (NAV goes down), 2) it creates a tax liability for the 8,000 remaining shareholders (but increases their cost basis).

Any individual seller pays capital gains on their unique difference in buy price vs. sell price, and the fund distributes capital gains on any difference between what it buys and sells.  This isn't "double taxation" because the capital gain distributions increase each individual's cost basis.

[Tortoise]

Thanks for the example, rickb. Makes a lot more sense to me now.