Ian Salisbury of the Wall Street Journal reported yesterday that for 2007, some ETF investors could be in for some unexpected tax demands.

While exchange-traded funds remain more tax-friendly than conventional funds, a few ETFs are passing out hefty capital-gain distributions to shareholders this year.

Among those that could carry a tax bite: State Street Corp.'s SPDR DJ Wilshire Mid Cap Growth ETF (EMG) -- which expects to hand out long-term and short-term capital gains amounting to about 6.2% of its assets -- and HealthShares Cardiology Devices ETF (HHE) that will pass out short-term gains, which are taxed at higher rates, of about 3.7% of assets.

Salisbury explains that ETF fund managers are increasingly unable to avoid distributing such capital gains, for several reasons:

Capital-gains distributions for all types of funds, not just ETFs, are expected to increase following a five-year bull market in which mutual funds steadily appreciated.

Moreover, in recent years, many funds have been able to offset gains with losses they recognized in the bear market of 2000-02. Increasingly, those losses have been used up.

There are also some factors particular to ETFs. ETFs wipe out capital gains when investors cancel existing fund shares to claim their underlying stocks. But for many thinly traded ETFs -- often funds that are new or narrowly focused -- that doesn't happen too often, giving fund managers few chances to eliminate gains.

Though most ETFs are not expected to distribute capital gains, Barclays' iShares estimates that six of its funds will this year, including iShares MSCI EAFE Value Index Fund (EFV), which will pass out a gain amounting to about 1.2% of its assets, two-thirds of which will be liable for higher tax rates. State Street expects 23 of its funds will be passing out capital gains.

As State Street's head of ETF product development, James Ross, puts it:

"Exchange-traded funds are very tax-efficient vehicles... They're not tax-free."

Further reading:

• iShares announces final year-end capital gains distributions.


• General tax advantages of ETFs in Seeking Alpha's The 7 Advantages of ETFs Over Index Mutual Funds

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By SA Editors