Have you streamed the latest ETF?

There is a process called ‘streaming’ that ETFs use that unlisted managed funds find too difficult. This means ETF investors have a tax advantage over investors in unlisted managed funds.

It’s probably more correct to say, ETFs give their investors a fair tax outcome. Unlisted managed funds, meanwhile, give their investors a tax disadvantage because they use a short cut.

To understand the difference, you have to picture a fund as a pool of investments with the ownership split between all the investors who hold units in the fund.

When the investments generate income, that income is divided between the investors based on the number of units each one holds. This includes income in the form of dividends, as well as capital gains from the sale of investments. At the end of the tax year, the tax liability on the income is attributed to the same investors that the income was attributed to.

During the ordinary operation of the fund this all works fairly. But consider what happens when investors redeem units and the fund gets smaller. The fund has to sell assets to pay the redemption proceeds and selling those asset sales can generate taxable capital gains. Who should pay the tax on those capital gains? Should it be the investors who redeemed? Or should it be the investors who remain in the fund?

What would be fair is that the investors who redeemed paid that tax. They caused the assets to be sold. What typically happens though is that the tax liability doesn’t get attributed until the end of the tax period and those investors are no longer on the fund register. This is where ETFs can do better.

For old-fashioned unlisted managed funds, redemptions that make the fund smaller can happen many times during the year. A fund rapidly losing popularity could have a redemption every single day they are open for business.

It is challenging for these funds to keep track of which investors caused the fund to get smaller at multiple points during the year and what taxable capital gains were derived at each of those points.

With the technology available these days you would think that this could be programmed. But managed funds are using systems that were developed a long time ago and they are not investing in improvements.

This is where ETFs have an advantage. With an ETF there is a market maker who holds an inventory of units. The market maker buys from investors who want to sell their units on the ASX and sells to investors who want to buy units. On a daily basis it is the market maker’s inventory that goes up and down rather than the size of the fund. The fund only gets smaller if the market maker builds up an excessive inventory and redeems some of it.

So, for an ETF, redemptions don’t happen often and when they do, they are bulky and it is easy for the ETF to track which market maker redeemed to calculate any capital gains that arise. The market makers have agreed up front to wear any tax liability caused by the redemption. This is called “streaming” the capital gains. As a result of streaming those investors who remain in the ETF will not incur the tax liability losses caused by a redemption. The tax liability is “streamed” to the market maker.

So if you don’t want to be in a fund where you have to wear the tax liabilities of those who have redeemed, choose an ETF rather than an unlisted fund.