"Cap gains exposure" of an ETF -- what does it mean?

Question

Morningstar provides an ETF data point called potential cap gains exposure. For example, here is Vanguard's Europe ETF (VGK):

This value is negative 78% for VGK. I understand that this is a good thing; the fund has accumulated a tax shield due to past losses. But what does this mean in reality? Does this mean the fund's assets can appreciate 78% before I have to pay capital gains taxes? How do I quantify this value so I can compare this fund to a similar international equity ETF such as VEA (which sports a much smaller tax shield but touts "tax-efficient management")?

Answer 1

Mutual funds (I expect this applies to ETFs as well) distribute all the dividends earned by the underlying investments to the share holders so as to avoid paying income tax (at corporate rates) on the earnings. Similarly, all capital gains due to selling some of the underlying securities, whether as part of the investment strategy of the fund (not a possibility for ETFs that are fixed portfolios) or because there is a net withdrawal of funds by investors that requires selling some of the underlying securities, are also distributed to the shareholders.

On the other hand, capital losses cannot be distributed to the shareholders but are carried forward and used to offset future gains. Such carry forwards used to be limited to eight years (after that, unused losses expired) but the tax law changed in 2010 and now losses can be carried forward indefinitely (losses that were subject to expiry before the law changed and were not all used up have now all expired). Some mutual funds also give information about unused capital losses on their web sites. So, if a fund is holding unused capital losses, it will not distribute capital gains until the losses are all used up.

Remember that a mutual fund's assets appreciating in value is not a taxable event to the fund or to the investor (it is an unrealized capital gain). A gain is realized only when the fund sells some of the underlying securities for a profit, and if the fund is holding some unused capital losses, the gains will be offset against the losses, resulting in a smaller loss carried forward to future years or a smaller gain to be be distributed to shareholders, depending on the relative sizes of the gain and the loss.

For a more detailed explanation of how a fund with a large negative potential capital gains exposure is a very tax-efficient investment, see what Morningstar has to say on the subject.