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.
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.