ETFs have seen rapid adoption by investors and advisors in recent years, but while the products themselves are known for their liquidity and transparency, what’s less understood is the tax bite some may deliver at the end of each year. With this in mind, Financial Planning spoke with Adam Patti, CEO of IndexIQ, to talk taxes and ETFs.
Q. Commodity ETFs have been one of the fastest-growing segments of the ETF universe, but many of these funds come with an added tax burden. Why is that?
A. Commodity ETFs that invest directly in physical commodities, such as gold or oil, and commodity ETFs that use futures and swaps, are both set up differently from other ETFs and mutual funds in that they are treated by the IRS as either limited partnerships or grantor trusts. That makes the funds non-taxable entities, and leaves all taxable events to flow through to the funds’ owners. If you’re not aware of this when you first invest in an ETF, it can be intimidating to open your mail one day and find a Form K-1 (for investments in partnership interests) waiting for you.
Q. So how can investors and advisors avoid this situation?
A. Some newer ETFs provide exposure to the major commodity sub-sectors by taking an equity-focused approach. The stocks of commodity producers, manufacturers, transporters and others often closely track the price movements of the hard assets with which they’re associated. But these funds don’t require K-1s and they allow investors to add targeted exposure to the commodities universe via the low-cost, liquid, transparent structure of an ETF.
Q. The K-1 situation you described above is not unique to commodity funds, since other alternative investments such as hedge funds, private equity and real estate also provide investors with K-1s. Can ETFs solve for structural limitations in these types of investments as well?
A. Yes. Hedge fund investors are also often on the receiving end of K-1s, as are investors in many ETFs and mutual funds that seek to position themselves as an inflation hedge, since often those funds are using as their underlying holdings vehicles like hedge funds, private equity or direct investment in commodities. This is another area where the ETF industry has stepped in to innovate and bring out products and solutions that provide access to hedge fund-like returns, such as those delivered by “liquid alternative” solutions like our first-of-its-kind hedge fund replication ETFs, which include QAI, MCRO and MNA. In this case, the underlying hedge fund replication indexes seek to capture the broad characteristics of hedge fund industry performance, and can provide investors with the types of exposure and return characteristics that meet their needs, but without any K-1s.
Danielle Reed writes for Financial Planning.