Most of the time when I have to write a rebuttal to something in the more mainstream press about ETFs, it’s all just about correcting the facts. Today is a little different.
Today I get to explain why something Bloomberg has laced with negative hyperbole—ETFs’ use of creation and redemption to minimize investors’ tax bills—is actually great.
The article in question pretty much starts with yellow and gets dingier from there. “Tax-dodge,” “dirty little secret,” “loophole” and “Nixon-era” are used to imply that something secret and nefarious is going on.
The core of the story is pretty simple. ETFs use in-kind transfers to minimize taxes. For anyone who’s paid any attention to ETFs, this isn’t a secret—it’s a core feature of the product and has been for 25 years.
The “news” of the story—that this process can be used to help a big fund do a rebalance, getting rid of Stock A to acquire Stock B—is also hardly news if you’ve been paying attention. We’ve been discussing this quite literally for years.
Lara Crigger has written extensively about it (not that the authors bother to cite her shoe-leather work here), and we’ve published FactSet’s Elisabeth Kashner going through the mechanics of it in exhausting detail.
Setting Things Straight
So what’s actually going on? Well, when a large fund wants out of Stock A and into Stock B, they find a friendly counterpart on the street who agrees to do two large trades. A creation, in which they deliver a custom basket of securities the ETF wants (Stock B), and a redemption, where they receive a custom basket of securities they don’t want (Stock A). By using the creation/redemption mechanism to do this, the ETF issuer:
- Minimizes the fund’s transaction costs.
- Minimizes the market impact of “dumping” and “piling up” in the two securities.
- Avoids having to pass through any potential capital gains on the old position.
Let’s walk through who the winner is here: the investor in the ETF. That’s it. That’s the walkthrough. As an individual, taxable investor, I benefit from not having to pay taxes on a sale I didn’t make, and probably get a slightly better execution on the pair of trades.
Consider the alternative. If you’re an ETF issuer, and you’re managing this portfolio, and this option is available to you (and is widely known, documented and has been available for 25 years), and you don’t take advantage of it, you’re effectively in breach of your fiduciary duty. This isn’t a way for the issuer to pocket more money. It’s not a wealth transfer to some third party on the street. This is pure, simple, efficient.
Funds that could, but didn’t, do this could probably be sued for mismanagement. The practice is so Boy Scout that Vanguard—Vanguard, the company with the strongest “little guy investor” brand in the world—is one of the biggest participants in heartbeat rebalance trading.
Rather than waste time rehashing the article (which essentially just summarizes work we’ve been writing for years, without a citation), let’s consider the alternative. Let’s imagine a world where in-kind creation/redemption went away. What would that look like? It would look like bad mutual funds.
First, it would shift the tax burden randomly to late-buyers of a fund in a calendar year. Let’s say Bob has been holding Dave’s Excellent Momentum Fund (ticker: DEMF) for a few years, and all the stocks have been just racing higher the whole time. He decides to sell out of the giant fund on Jan. 15.
The fund has to sell a giant pile of stock that’s all appreciated in value. Bob will pay taxes on the capital gain he personally experienced between when he bought DEMF and when he sold it. That’s fine. But DEMF has to record a huge capital gain, which now sits on its books.
Eleven months passes. DEMF gets crushed. It’s down 50% (I never claimed I could manage money). On Dec. 15, Alice finds DEMF, and figures it’s now nearly a value fund in disguise, and buys in big. A few days later, she gets an enormous capital gains distribution, on which she has to pay taxes. Now, sure, she gets to adjust her basis, but that will only matter when she sells. Right now, she’s just been handed back a huge chunk of her investment and a tax bill.
This is how most mutual funds work, and it’s inherently awful and unfair, and frankly it’s shocking it’s even legal under the tax code.
ETFs reset this math by matching Bob’s and Alice’s tax liabilities to their actual investment experience.
That core principle—of tax fairness—is what underpins all this.