MSCI index shift poses ETF tax threat

Many investors in emerging markets exchange traded funds risk an unexpected tax bill if a potential upgrade of South Korea and Taiwan this month to developed-country status in a key market benchmark goes ahead.

A rebalancing of MSCI’s emerging market index would expose US holders of ETFs based on the benchmark and other similar indices to taxable capital gains, drawing attention to the increasing complexity of the fast-growing market for exchange traded products.

On June 21, MSCI will announce the results of its annual market classification review. The index provider is considering whether to reclassify MSCI Korea and MSCI Taiwan as developed markets. The two countries represent 14 and 11 per cent of the MSCI emerging markets index, and the resultant rebalancing would be one of the largest on record.

Investors hold $87bn in ETFs based on the index run by Vanguard and BlackRock’s iShares, representing 8 per cent of ETF assets.

ETF providers typically try to avoid crystallising capital gains, which must be distributed to investors, generating a tax liability. Carrying forward past losses and using in-kind securities rather than cash to manage ETF holdings helps minimise such liabilities. But stock markets in South Korea and Taiwan have risen strongly over the past five years and local rules prohibit in-kind transactions.

Any rebalancing of the ETFs would require selling the underlying securities for cash.

“The tax efficiencies of ETFs have been way oversold,” said Joel Dickson, head of active quantitative equity for Vanguard. “Most of the tax efficiencies have resulted because they are indexed investments.”

Diane Hsiung, a senior portfolio manager for BlackRock, said: “Whenever we sell securities in a fund there may be a tax consequence.”

Neither company would speculate on what the tax effects might be but a big bill would undermine some sales efforts.

For instance, a State Street document, called The importance and use of ETFs in a rising tax environment, said that exchange traded funds’ tax efficiencies and low expenses would become more attractive, especially to high income taxpayers.

Scott Ebner, head of ETF product development at State Street Global Advisors, said: “Being relatively tax-efficient doesn’t mean you’re immune to taxes.”

The possible MSCI rebalancing would draw attention to criticism in BlackRock’s first quarter review of the industry. “Product developers are working hard to find ways to put structured products, hedge funds and active funds into an ETF wrapper,” the report said. “If this pattern is allowed to continue, this could be very negative for the ETF industry.”

The report urged “greater transparency around product structure, mechanics, tax and regulatory implications, index replication methodology and pricing”.

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