The Heartbeat Of ETF Tax Efficiency

January 03, 2018

[Editor’s Note: The following originally appeared on FactSet.com. Elisabeth Kashner is director of ETF research and analytics for FactSet.]

ETFs are known for tax efficiency, particularly around annual capital gains distributions. Their in-kind redemption process allows for the washing out of appreciated stock positions. Think of it as a holiday gift from the IRS to ETF investors, via its special tax treatment of market makers.

Yet day-to-day trading activities sometimes don’t create enough opportunity to wash out gains, especially when portfolio turnover is high. In fact, if a portfolio manager must rebalance on a particular date, she runs the risk that no client will choose to redeem shares that day.

Given that many funds have minimal or sporadic redemptions, it’s a miracle that most high-turnover ETFs don’t distribute capital gains. 

‘Unheralded Act Of Generosity’

Actually, it's better than a miracle. It's an anonymous, unheralded act of generosity. Behind the scenes, someone provides short-term capital to fund share creations in ETFs slated to rebalance their portfolios. The capital is required for less than a week, and often for just one to three business days.

The capital can be returned as soon as those shares are redeemed. This short-term access to capital allows ETF portfolio managers to essentially manufacture redemptions that wash out capital gains that would otherwise be realized in a rebalance. 

Put another way, something like a short-term loan—sometimes over $1 billion in market value—is behind ETF tax efficiency. 

This practice is common in the ETF industry. Evidence of large inflows that reverse on rebalance day can be found in ETFs from almost all large asset managers, and in many of the funds from smaller issuers as well. Once you know what to look for, it’s easy to see these extraordinary flows. They look like an EKG tape. 

The VanEck Vectors Morningstar Wide Moat ETF's (MOAT) three-year flows chart shows a healthy-looking pattern of huge inflows and matching outflows two business days later.

 

ETFExplainerXLB

For a larger view, please click on the image above.

 

MOAT’s “heartbeat” flows are truly extraordinary. They skew the scale of the chart, rendering normal flows almost invisible.

Since Jan. 1, 2015, MOAT has had flows—in or out—207 times, excluding rebalance days. The most common was a single creation unit, or 50,000 shares. Outflows were rarely bigger than 200,000 shares.

 

ETFExplainerXLB

For a larger view, please click on the image above.

 

 

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