Traditional ETFs are generally tax efficient because the in-kind creation and redemption mechanism limits taxable events. Conversely, leveraged index ETFs have high portfolio turnover as they rebalance their portfolios daily in response to market movements and do not experience a significant level of inkind creation or redemption transactions. As a consequence, leveraged ETFs are generally not tax efficient, at least by the standards of traditional ETFs.
Distributions are generally not good for long-term investors in taxable accounts because such investors seek to:
- Delay recognition of gains to allow such gains to compound through time (before paying taxes on the gains) and
- Benefit from the lower tax rate on long-term capital gains.
Market commentators seem to look at distributions from the perspective of the long-term investor and therefore view distributions negatively.
Long-term investors are not appropriate users of leveraged index ETFs. Dynamic asset allocators and traders, however, are appropriate users and they do not have the same sensitivity to distributions as long-term investors. Traders generally do not seek to delay recognition of gains (or deferral of taxes) and, as a consequence, generate short-term capital gains, which are taxed as ordinary income. As a consequence, a trader will be negatively impacted from a tax perspective by a distribution only if the distribution exceeds the amount of the trader’s short-term capital gains in the current calendar year.
The Following Hypothetical Example Illustrates the Point
For calendar year 2021, Trader Mary has net short-term capital gains of $200,000 from trading stocks and ETFs before she liquidates all of her positions and heads out on her annual two week Thanksgiving holiday on November 19th.
Refreshed from her vacation, Trader Mary resumes trading.
- On December 6th, she invests $100,000 in a leveraged ETF, buying 10,000 shares at an NAV of $10.00.
- On December 10th, with the NAV still at $10.00, the leveraged ETF makes a distribution of $1.00, all of which is short-term capital gain which when distributed by the ETF, is treated and taxed as ordinary income to the ETF shareholders. The NAV of the ETF declines by $1.00 from $10.00 to $9.00.
- On December 15th, with the leveraged ETF NAV at $9.00(meaning that the NAV has not moved due to market action during Trader Mary’s holding period), Trader Mary sells all of her shares. She now has her original $100,000. Since she was an owner of the ETF when it made a distribution, she will be taxed on the $10,000 distribution she received as ordinary income.
Has Trader Mary Been Harmed By the Distribution?
As a consequence of her investment in the leveraged ETF, Trader Mary now has:
- $10,000 of ordinary income from the distribution and a $10,000 short-term capital loss caused by the sale of the position at the lower (due to the distribution) NAV.
- The $10,000 short-term capital loss reduces her $200,000 short-term capital gain, leaving Trader Mary with $190,000 of short-term capital gains and $10,000 of ordinary income.
Short-term capital gains are taxed as ordinary income at Trader Mary’s effective tax rate of 35%. Therefore, Trader Mary’s tax liability is still $70,000. She is no worse off because of the distributions.
| Short Term Capital Gains (Loss) | Ordinary Income | |
| From Trading | $200,000 | |
| Directly From Distribution | $10,000 | |
| From Sale of Shares (Indirectly from Distribution) | ($10,000) | |
| Aggregate Taxable Income | $190,000 | 10,000 |
In practice, few people like distributions. However, for traders, the issue tends not to be an economic one centered on taxes but rather a practical one based on market exposure—distributions reduce exposure.
Capital losses generally cannot be used to offset distributions of income or short-term capital gains, which are treated as ordinary income when distributed by the ETF, so a trader (unlike Trader Mary) who has no short-term gains that can be offset by the short-term capital losses she recognized on the sale of her ETF shares in a year in which she receives a distribution will be disadvantaged by the distribution. If instead the distribution comprises long-term gains, short-term capital losses from the sale of the position will generally offset the distribution under special U.S. federal income tax rules, and therefore, there is no negative tax impact.
This material is for information purposes only and does not constitute investment, legal or tax advice. You should contact your legal or tax advisor regarding your specific tax situation prior to taking any action based upon this information.
An investor should carefully consider a Fund’s investment objective, risks, charges, and expenses before investing. A Fund’s prospectus and summary prospectus contain this and other information about the Direxion Shares. To obtain a Fund’s prospectus and summary prospectus call 866-476-7523 or visit our website at direxion.com. A Fund’s prospectus and summary prospectus should be read carefully before investing.
Investing in a Direxion Shares ETF may be more volatile than investing in broadly diversified funds. The use of leverage by an ETF increases the risk to the ETF. The Direxion Shares ETFs are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged, or daily inverse leveraged, investment results and intend to actively monitor and manage their investment. The Direxion Shares ETFs are not designed to track their respective underlying indices over a period of time longer than one day.
Direxion Shares Risks - An investment in the ETFs involves risk, including the possible loss of principal. The ETFs are nondiversified and include risks associated with concentration that results from an ETF’s investments in a particular industry or sector which can increase volatility. The use of derivatives such as futures contracts and swaps are subject to market risks that may cause their price to fluctuate over time. The ETFs do not attempt to, and should not be expected to, provide returns which are a multiple of the return of their respective index for periods other than a single day. For other risks including leverage, correlation, daily compounding, market volatility and risks specific to an industry or sector, please read the prospectus.
