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Tax Issue On Short ETFs Hits The Fan

Tax Issue On Short ETFs Hits The Fan
December 31, 2008

SAN DIEGO (ETFguide.com) - It’s no secret anymore. Short ETFs have become the most popular and least tax efficient class of index ETFs.

Earlier in December, Rydex announced huge tax distributions. Just a few weeks later, ProShares followed suit with unexpectedly large capital gains tax distributions.

Unlike Rydex, ProShares did not pre-announce the tax distribution date (ex-date). In an effort to provide a “heads-up” and a way to avoid the tax bite, ETFguide pointed out in advance that last
year’s distribution date for ProShares ETFs fell on December 20th.

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Rydex, the leader in currency ETFs, shocked ETF investors with distributions ranging from 11.98% to 86.61%. Along the same line, ProShares surprised with capital gains tax distributions ranging from 4% to 44%.

A look at the chart reveals that over 35 ProShares short ETFs dropped significantly from December 22nd to December 23rd. The UltraShort Industrials (NYSEArca: SIJ) dropped 44.3%, the UltraShort Basic Materials (NYSEArca: SMN), UltraShort Utilities (NYSEArca: SDP) and UltraShort Russell 2000 Growth (NYSEArca: SKK) dropped between 36% and 38%.
  

 
Below is an excerpt from the ETF Profit Strategy Newsletter – Published on Oct.21, 2008
At the time, the Dow was above 9,000. It dropped below 7,500 and rallied into Nov./Dec

Market Meter

Short-Term: published on Oct. 21, 2008
The Dow should find a “trade-able bottom” between 7200 – 7,500
Mid-Term: published on Oct. 21, 2008
Once bottomed, the stock markets will rally into Nov/Dec
Long-Term: >> Sign up to find out


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The good news is that the ETFs did not actually lose some 30 or 40% of their value. The amount of the tax distribution is reflected in the reduced share price. For example, $10,000 invested in SIJ would result in a 44.11% drop in SIJ paralleled by $4,411 cash payment from ProShares to the shareholder. The $4,411 is taxable as income (short term capital gain) if not held within a tax-deferred account.

Not all of Rydex or ProShares’ capital gains tax distributions were considered short term gains. Some were long term, others were a mix of long-and short term capital gains. Long term gains are taxed at a more favorable 15% rather than being counted as income.

How can this happen? Don’t ETFs have a reputation of tax efficiency?

Yes, they do. Due to the unique redemption process of index 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 ETF 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.

How can I avoid the tax-bite?

In short, don’t own the ETF when the distribution becomes effective (called the ex-date). The ex-date for Rydex was December 9th, for ProShares the ex-date was December 22nd. If you don’t own the ETF on this day, you are not liable for any taxes. Rydex announced the ex-date weeks in advance to give investors a chance to escape, ProShares did not.

Lesson learned: know what you own and beware of little-known but important details. If you don’t know yourself, find someone who does.

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