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Renewable Energy and Cleantech Mutual Funds and ETFs: Does Tax Efficiency Matter?

My recent article, In Clean Energy, Active Management Pays, started a bit of a controversy. Rafael Coven, the Index Manager for The Cleantech Index (^CTIUS), which is the index behind the Powershares Cleantech Portfolio (PZD), left a comment on Barrons and sent me an email saying, "Your comparison of funds and ETFs ignores the tax efficiency differences which are very significant."

Rafael is right that it's important for many investors to consider taxes before making an investment decision, and that ETFs are often more tax efficient than mutual funds.  But are the differences in the particular case of clean energy funds really "very significant"?  I had my doubts, so I decided to look at the numbers and find out.

Why ETFs are Usually More Tax Efficient

ETFs are generally considered more tax efficient because they make fewer capital gains distributions.  A mutual fund or ETF that sells a position at a profit is required by law to return a prorata share of any net capital gains to the fund's investors every year.  Positions held less than a year produce short term capital gains, while positions held more than a year produce long term capital gains.  When these gains are returned to investors, they are taxable as short or long term capital gains, regardless of whether the funds are reinvested.

In general, actively managed mutual funds trade much more often than ETFs, which passively track an index.  While many mutual funds trade much of their portfolio once or more a year, most ETFs only trade a tiny fraction of their portfolio in order to keep up with changes in the underlying index.  

Hence a mutual fund with a Turnover Ratio of 100% (meaning that, on average, 100% of the funds holdings are traded each year) will, on average, only hold a position for a year, and will distribute the majority of capital gains to shareholders every year, much of which will be in the form of short term capital gains, which are typically taxed at a higher rate than long term capital gains.   In contrast, an ETF with a Turnover Ratio of 10% will, on average, hold a position for ten years.  This allows time for significant undistributed capital gains to build up, and when those capital gains are distributed, they almost always come in the form of long term capital gains, which are usually taxed at a lower rate.

Who Needs to Worry About Tax Efficiency, and Who Doesn't

Not all investors need be concerned about the tax efficiency.   Most obviously, investors who are investing in a non-taxable account, such as an IRA and a 401(k).  Tax exempt institutions, such as charities, also need not worry about tax efficiency.  Finally, people in lower tax brackets need be less concerned than those with high incomes, since the taxes on capital gains distributions will be lower for them.

Undistributed Gains

Most renewable energy stocks are down significantly over the last three years (roughly the same period as the track record of most of the ETFs.)  This means that, at least in the short term, many mutual funds and ETFs will not have any capital gains distributions no matter how well they perform, because previous year's capital losses will be available to offset future gains.  (While funds are required to distribute realized capital gains, they have no way of distributing realized capital losses, except for offsetting future gains.)  

The Numbers

Morningstar has data on most fund's tax efficiency, including adjusted returns assuming distributions are taxable, and potential capital gains exposure (undistributed capital gains as a percentage of net assets.)  The following two tables and charts compare the ETF and mutual fund three year returns on both tax adjusted and unadjusted basis, along with potential capital gains exposure and fund turnovers.  Where possible, I used no-load mutual fund shares because I feel they are more comparable to ETFs than load shares, despite the fact that long term mutual fund buyers should generally prefer load shares because of their lower annual expense ratios.




etf tax chart.png
mutual fund tax chart.png

As you can see from the tables, the ETFs have indeed been more tax-efficient than the mutual funds, but the differences are so marginal that they are difficult to detect in the charts.  

More striking are the extremely large negative capital gains exposures of many mutual funds and ETFs.  The DWS Climate Change Fund (WRMSX)Guinness Atkinson Alternative Energy Fund (GAAEX), Van Eck Global Alternative Energy Fund (GEX), and the PowerShares Clean Energy (PBW) all have undistributed capital losses equal to multiples of the funds' current values (260%, 241%, 234%, and 198%).  That means that all the holdings in each fund's portfolio could be sold for three or more times their current value and the funds would still not have to distribute any capital gains.   Tax efficiency will remain a moot point for years to come, at least for these four funds, as well as for the PowerShares Global Clean Energy Portfolio (PBD) and the Calvert Global Alternative Energy Fund (CGACX).

The only fund for which I can really call tax efficiency a concern is the Gabelli SRI Green Fund (SRICX).  Why does the Gabelli fund stand out as having a "problem" with tax efficiency?  Because the Gabelli fund actually managed to turn a decent profit over the last three years, while their clean energy mutual fund and especially ETF rivals lost money hand over fist.  I recently interviewed John Segrich, CFA, the lead fund manager at the Gabelli SRI Green fund, and he explained in part how they did it.

When it's a sign you're making money, tax inefficiency seems like a good "problem" to have.  

Turnover

It's also worth noting the fairly high Turnover ratios of all of the ETFs, ranging from 30% to over 60%.  That means that, on average, the holdings of Clean energy ETFs trade once every 2-3 years, which is not enough time to build up substantial unrealized capital gains, although the majority of capital gains distributions are likely to be in the form of long term capital gains.  In fact, the New Alternatives FD Inc (NALFX) has a lower turnover ratio than all but one of the clean energy ETFs.

Even when we return to an environment where most of these funds are habitually making gains, and the negative capital gains exposures of many of the funds are exhausted, these ETFs will have less of an advantage in tax efficiency over the clean energy mutual funds than broad market ETFs have over their peers, unless the ETF turnover ratios fall faster than those of the mutual funds.  

Conclusion

While Clean Energy ETFs are a little bit more tax efficient than Clean Energy Mutual Funds, the difference is not currently significant.  Clean Energy is a very young sector with high volatility and quickly changing industry structure.  The changeable nature of the clean energy landscape means that a lot of the usual rules do not apply.  Not only do active managers have a significant advantage over passively managed funds like ETFs, but passive clean energy funds also have much less significant tax advantages than passive broad market funds.

DISCLOSURE: No Positions. GAAEX is an advertiser on AltEnergyStocks.com.  

DISCLAIMER: The information and trades provided here are for informational purposes only and are not a solicitation to buy or sell any of these securities. Investing involves substantial risk and you should evaluate your own risk levels before you make any investment. Past results are not an indication of future performance. Please take the time to read the full disclaimer here.

ETF 3yr pretax 
total return 
3yr tax adj 
total return
Potential Cap 
Gains Exposure
Turnover
QCLN -43.34% -43.34% -52% 40%
PZD -28.31% -28.38% -40% 31%
PBD -56.22% -56.28% -98% 62%
GEX -64.96% -65.03% -198% 50%
PBW -59.90% -59.90% -234% 42%
ICLN insufficient track record
-64%
Mutual Fund
3yr pretax 
total return
3yr tax adj 
total return
Potential Cap 
Gains Exposure
Turnover
WGGFX -38.09% -38.76% -46% 93%
NALFX -36.19% -39.81% -25.00% 34%
CGACX -61.73% -61.73% -110% 61%
AECOX -48.72% -51.72% -68% 39%
GAAEX
-66.23%
-67.52%
-241%
47%
WRMSX -42.70% -42.88% -260% 114%
SRICX 15.43% 12.65% 0.60% 190%
ALTEX -33.01% -33.01% -22.18% 41%
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