The Players Behind ETF Tax Efficiency

March 23, 2018

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

ETFs are famous for their tax efficiency. This advantage, along with low operating costs, transparency, and the benefits of passive investing, is catapulting ETF assets to new heights, as mutual funds lose clients.

Yet the trading activities around ETF portfolio rebalances are not free. In fact, this is one area where ETF transparency can bring additional costs.

Following the portfolio rebalance money—the inflows, outflows, and trading activity in the underlying securities—makes these costs knowable. The money trail is complex, but traceable.

Understanding The Players’ Roles

The first step is to understand the players and what role each plays. This article identifies the players. An article on trade forensics will come next, followed by a cost/benefit analysis.

All are follow-ups to the revelation that ETF tax efficiency is often attributable to massive inflows and outflows around their rebalance dates, which constitutes part one of this series.

ETFs’ tax efficiency comes from the ability of ETF portfolio managers to trim positions via in-kind redemptions, rather than outright sales, thus avoiding incurring capital gains. Complex indexes such as those underlying most “smart beta” funds require periodic rebalances to keep the strategy on target.

The practice of selling winners and replacing them with fresh prospects is key to these strategic indexes’ value proposition, but also introduces the risk of capital gains tax liability.

In-kind redemption allows portfolio managers to swap low-basis securities for ETF shares tendered, without realizing capital gains, as the low-basis positions are exchanged, not sold. The higher an ETF portfolio’s turnover, the greater the benefit of (and the need for) in-kind redemptions. Turnover takes place as indexes rebalance and reconstitute themselves.

The need for redemptions attracts market makers and incentivizes portfolio managers to collaborate with them to optimize tax efficiency. Market makers profit off these trades by front-running the rebalance, potentially eating away at a strategy’s potential for out-performance.

Many ETF rebalances leave two kinds of traces in the capital markets: one in the ETF itself and another in the securities the ETF holds, aka the portfolio securities. The trail starts with the ETF itself.

Heartbeat Flows: Whose Cash?

ETF rebalances are often accompanied by a “heartbeat” pattern in fund flows, with a huge inflow to the ETF a day or two ahead of the rebalance, and a matching outflow on the rebalance day. The first step in exploring these trades comes in tracking the source of the heartbeat cash.

The most plausible candidates are asset management firms and trading firms. Other types of lenders would likely shy away from the overnight exposure to changes in asset prices, as one day’s adverse movements in the stock market could easily wipe away any interest charges.

Put another way, the basis risk is too high to make this loan profitable for anyone who cannot hedge it, or otherwise offset the risk.

Asset managers benefit from eliminating capital gains exposure, while trading firms benefit from executing trades in the securities markets. Although asset managers have plenty of reason to lend capital to their portfolio managers in order to set up an outflow, they are legally prohibited from doing. This would constitute self-dealing.

 

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