If you're an ETF investor, you may wonder why you're seeing some red ink even as the market enjoys a nice Santa Claus rally. Fortunately, there's a good explanation, and it means more money in your pocket.

Flash crash revisited?
No, the share declines you may be noticing in your exchange-traded fund portfolio aren't the stealth equivalent of a flash crash. Rather, they stem from distributions that ETFs traditionally make toward the end of each year.

What many people don't remember about ETFs is that for tax purposes, they get the same treatment as traditional mutual funds. In particular, ETFs have an advantage over most corporations in that ETFs don't have to pay taxes on their income and capital gains at the fund level. In order to avoid corporate-level taxation, however, they're required to pay out all of their income and capital gains to shareholders in the form of share distributions. Then, shareholders must treat the fund's taxable income as their own, including income and capital gains on their individual tax returns.

Over the years, mutual funds have been notorious for their ill-timed distributions, forcing shareholders to bear a heavy tax burden even when some of them never benefited from the investments that created the profits that are being taxed. For instance, in 2008, many mutual funds paid capital gains distributions despite the stock market's plunge, adding insult to injury for beaten-down shareholders.

Because of the way ETF shares are created and redeemed, ETFs tend to be more tax-efficient than traditional mutual funds. But that doesn't mean ETFs escape taxes entirely. As a result, most still make distributions.

Why your money isn't disappearing
The scary thing about year-end distributions is that your shares can drop substantially in value without your necessarily knowing why. Take a look at these recent moves:



One-Day Price Drop

iShares Barclays MBS Bond (NYSE: MBB) Dec. 1 (3.1%)
WisdomTree Dreyfus Brazilian Real (NYSE: BZF) Dec. 22 (11.5%)
Vanguard European ETF (NYSE: VGK) Dec. 22 (4.5%)
Direxion Daily 7-10 Treasury 3x (NYSE: TYD) Dec. 14 (7.3%)

Source: Yahoo! Finance, ETFdb.com.

Even well-known ETFs see this phenomenon to some degree, although the moves aren't necessarily as big. Vanguard Emerging Markets ETF (NYSE: VWO) and iShares MSCI Brazil ETF (NYSE: EWZ) saw distributions of around 1% and 3%, respectively.

In addition, more big moves may yet be coming from other funds. Market Vectors Brazil Small Cap (NYSE: BRF) has declared a capital gains distribution of $2.63 per share for today, which represents 4.6% of yesterday's closing price.

But typically, the fund has simply dropped by the amount of the distribution. Here's a rough timeline of events that occur whenever an ETF makes a distribution:

  • Fund companies typically pre-announce the record dates for dividend payments, although in some cases they won't give the exact dividend amount until after the payment is determined.
  • On the appropriate date, the shares will go ex-dividend, meaning that if you own ETF shares at the beginning of that day, you'll be entitled to receive the dividend payment -- even if you decide to sell those shares as early as later that day.
  • Only later will you see those dividends actually credited to your account. Depending on the arrangements you have with your broker, you may receive cash from the distribution, or it may automatically be invested into additional ETF shares. Regardless of what happens to the money, though, you have to account for it on your taxes unless you own the shares in a tax-deferred account like an IRA.

Be patient
So if you've seen a big drop in your ETF portfolio value and don't know why, take a look and see if any of the ETFs you own have declared distributions lately. Odds are that if they have, the paper loss that suddenly appeared in your account will go away once the ETFs actually pay out those dividends.

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