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.
So now we move on to the “heartbeat” trading (which, again, is not “secret,” as we’ve been covering it forever, and is not a “dodge,” and has absolutely nothing to do with Nixon).
Imagine Alice puts her giant investment in the day before a big rebalance, but in-kind creation redemption has been outlawed. Let’s say that big rebalance happened on Jan. 15 again, and Alice invests on Dec. 15 again. What happens? The same thing. Alice gets hit with a huge distribution and tax bill, for an investment experience she didn’t even participate in!
‘Wealthiest Americans’ Gambit
So, if the current system is somehow curious and seems like a “dodge” to some folks, the alternative system is an absolute train wreck of unfairness that inevitably traps smaller investors (who probably don’t follow index rebalance dates in the Google calendar). Yet the Bloomberg article in question tries to imply they have a smoking gun by linking to a big academic paper with this quote:
“It’s the equivalent of a $23 billion, no-interest loan from the U.S. Treasury to ETF investors, with most of the benefit going to the wealthiest Americans.”
Gee, that paper must really prove that it’s the wealthy taking advantage of this.
In fact, that paper is simply an analysis of wealth inequality in the U.S. That’s a real problem in this country, for sure. But the way to solve it isn’t by shifting tax burdens down to retail investors.
I don’t know the household net worth of every investor in every ETF. But I do know that paper doesn’t contain the word “ETF,” and barely touches on taxation.
A Bit Of “What If?”
So now what? I’m a fan of the phrase “reasonable people can disagree,” because honestly, I think too much public discourse these days devolves to shouting. But in this case, I’m not sure I see the “reasonable” other side.
If we wiped out this tax treatment, sure, the Treasury would collect a little more tax from individual investors today, and just not collect that later. Smart, wealthy investors would simply move to other tax-deferred structures like exchange-traded notes, derivatives and tax-managed hedge funds. Of course, there’s no guarantee that the money the Treasury would collect now would be more than the money collected at the future point in time when investors sell their ETFs.
And let’s be absolutely clear: ETF investors are paying taxes, and doing so completely fairly. They’re paying when they sell, not when other people sell, and not because the portfolio rebalanced months before they bought in.
But let’s imagine I’m an idiot (plenty of people have asserted it before). Let’s imagine that the new ETF rule never happens (which actually makes this kind of creation/redemption activity more fair across the industry, rather than restricting it). Let’s imagine there’s a huge groundswell of support to change all this. How would that work exactly?
I’m pretty sure it would take legislation. I don’t believe this is “rulemaking” territory. This is rewriting Title 26 of the Internal Revenue Code. I don’t know about you, but this strikes me as incredibly unlikely. We just finished throwing the IRC in a blender in 2017 and I don’t know that many folks who are stoked to go for round 2 to tax retail investors more quickly (and it’s just a timing shift, not a net-tax shift).
On a day when we should be celebrating the incredible benefits ETFs have brought to average, everyday investors (the ETF.com Awards were just last night!), it’s disappointing to me to have to wade in, yet again, to set the record straight.
I guess it’s a sign of success. If ETFs were heading to the dustbin, there’d be no headlines.
Dave Nadig can be reached at [email protected]