by Michael Johnston on November 18, 2009 | ETFs Mentioned: REC

Bethesda, Maryland-based ProShares announced on Tuesday that it expects to pay zero 2009 year-end capital gains distributions on all 77 of its leveraged and inverse equity and fixed income exchange-traded funds, putting at ease any investors who had been questioning the tax efficiency of leveraged funds. While we manage ProShares to minimize capital gain distributions, a myriad of factors may impact the level of capital gains that tax regulations require to be distributed, said Michael L. Sapir. Chairman and CEO of ProShare Advisors LLC, ProShares investment advisor. In contrast to last year when the funds were faced with a confluence of highly unusual circumstances with respect to such factors, this year presented circumstances that we view as more typical.

In 2008, several leveraged ETFs made significant year-end capital gains distributions, most notably the Rydex 2x S&P Select Sector Energy (REC ) which paid out more than 80% of its NAV. This came as a very unpleasant surprise to many investors who embraced ETFs in part because of their enhanced tax efficiency relative to traditional actively-managed mutual funds.

Under most circumstances, leveraged in inverse ETFs do exhibit the same efficient tax features of unleveraged, long funds. But because leveraged and inverse ETFs use swap agreements to achieve their results, there exists the potential for big capital gains payments at the end of the year (John Gabriel does a good job of explaining exactly why this can occur here. as does Matt Hougan here ). While the few large outliers in 2008 received the bulk of the coverage in the financial press, capital gains distributions for most leveraged ETFs were minimal (or zero) for the year.

ProShares was the first of the three leveraged ETF issuers to comment on expected distributions for the 2009, with upcoming distributions from Direxion and Rydex still to be determined. But the news from ProShares bodes well for a corner of the ETF industry that has seen a great deal of negative publicity in the last two years, much of it undeserved. Even if some funds do end up making distributions making distributions, they are likely to be significantly smaller than payouts in 2008.

Not everyone is convinced that leveraged ETFs are out of the woods quite yet. The largest gains in 2008 were concentrated in smaller funds, and if I were a tax-sensitive investor, I’d be worried about funds with small assets under management going into the 2009 distribution season, writes Matt Hougan for Index Universe. Hougan goes on to note that the resources available to ETF providers to manage tax distributions, such as use of the creation/redemption process to distribute gains throughout the year, may not be available for smaller leveraged ETFs. While this is certainly a valid concern, ProShares has several ETFs with a market capitalization of  less than $10 million, and didnt seem to have any issues avoiding distributions.

The Old Normal

Theres been a lot of talk about the new normal, a term coined by PIMCO executive Mohamed El-Erian to describe an upcoming period of muted growth in developed economies as emerging markets become increasingly important to the global economy. But for leveraged ETF issuers, the return to an old normal where the VIX stays below 80 and triple digit swings in the Dow are the exception rather than the rule must be a welcome development.

Because most leveraged ETFs have a daily focus. their performance over multiple trading sessions depends on both the change in the relevant benchmark and the direction of the market during that period. In 2008, unprecedented volatility in financial markets caused significant return erosion over time in several popular leveraged ETFs. As investors who failed to educate themselves (or their clients) on the underpinnings of these products cried foul, the perception that leveraged ETFs are unpredictable, even malicious products spread. This, of course, simply isnt true (see our feature story debunking several leveraged ETF myths here ).

As volatility has returned to near its historical average, many investors have learned that there are two sides to the leveraged ETF coin, and that compounding can actually work for investors in many markets (for those with an appetite for statistical analysis, ProShares Joanne Hill recently made a rather thorough presentation on the topic). Despite restrictions on their use by many major financial institutions, leveraged ETFs continue to enjoy tremendous popularity among investors who use them for a variety of purposes, both simple and complex.

The announcement of no capital gains distributions for the year should go a long way towards debunking another myth about leveraged ETFs. Those who feared that leveraged products generally lack the tax efficient characteristics that have made ETFs the investment vehicle of choice for so many now have some compelling evidence to the contrary.

Disclosure: No positions at time of writing.

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