Compounding Made Simple: Ending the Dividend Tax Trap

A fear of ordinary income taxation keeps some investors from choosing the right assets for their portfolio. Alexander Morris, CEO of F/m Investments, shared with ETF.com's Dave Nadig how their new Compoundr ETF suite solves for this by turning bond income into capital gains at the Astoria Macro Summit in October. Through a simplified, transparent process, the strategy makes use of heartbeat trades to create painless compounding with tax-deferred advantages. 

Transcript

Morris: Why would you choose an investment purely because of taxes? You really shouldn't, but lots of investors do. Bonds fall into that trap. We hear so often, "Oh, I love this product, or I love this idea, I love this theme, I want the diversification, but I can't get it in my 401(k). I can't get it in somewhere I'm not going to pay income," because we've drilled into investors, "Bonds equal income, income equals taxes, tax is bad."

Solving Ordinary Income Tax Angst 

Nadig: You guys launched a product that I was pretty excited about a little while ago that kind of just sort of gets you out of the dividend business. Will you walk us through what the idea there is and why you're getting some traction with it?

Morris: Sure. So, Compoundr, no E in Compoundr. So if you look at F/m, you realize we just hate spell check. We just like, “How can we make your spell check have a bad day?” That's us. But also, we sell bonds. We do a lot of bond work, and bonds generally generate ordinary income, which for a long-term, most folks don't like. I mean, there’s a lot of ways to try to defer or avoid taxes – evade is bad, those other words depending on what your compliance officer let’s you do. And how do you change that?

And our thought has been, why would you choose an investment purely because of taxes? You really shouldn't, but lots of investors do. Bonds fall into that trap. We hear so often, "Oh, I love this product, or I love this idea, I love this theme, I want the diversification, but I can't get it in my 401(k). I can't get it in somewhere I'm not going to pay income," because we've drilled into investors, "Bonds equal income, income equals taxes, tax is bad."

Why should you not have the portfolio you should have because you're afraid of maybe paying taxes in the future? Seems weird. But we also recognize that compounding is just a real force. It's the eighth wonder of the world, right? Warren Buffett made very clear, compound interest works in your favor. How can we kind of achieve both? So, the Compoundr Series does that by using this really interesting feature of ETFs, and it's the 40 Act accounting rules, right? And I appreciate no one wants to talk about accounting rules.

But ETFs don't accrue income like a mutual fund, where they pay out this little teeny tiny dividend every day, and once a month they send you the money. ETFs can't do that. So you'll watch ETF's value go up over the course of a month or a quarter, they pay a dividend, it drops, off it goes. It's sort of sawtooth.

Nadig: More like a stock.

Morris: Just like a stock, because they are like stocks in that sense. Bonds accrue income every day, they meet each other, where now ETFs can allow you to basically own a bond for a period of time, but not pay income, because you don't necessarily collect that dividend. Compoundr does just that. So take CPAG, which goes after the Agg. We buy AGG, we'll hold on to it. Before the Agg pays its dividend, we rotate out of AGG into something like AGG, but not AGG. And then we rotate back into AGG when we're ready. Same is true for high yield. You'll see us do that with a handful of other securities, and you'll watch us go into these very cash return-rich asset classes: BDCs, mortgage REITs, places where most of your return is taxable income, but you don't actually want the cash out today. Because most folks in those securities, by the way, they reinvest their dividends.

Compounding Made Effortless

Nadig: Right. So, they're already going to compound anyway internally. What about the – I mean, you're recharacterizing some income as gain in that case, aren't you? And so, how does that impact the average investor when they're thinking about their taxes?

Morris: So, if your average investor who'd otherwise get your 1099, you'd have to sell something or otherwise find money to…

Nadig: Find some cash.

Morris: Find or pay there, not reinvest, do something else. Here you do absolutely nothing. You just wait. When you're ready to sell, you sell. You get your 1099 for your long-term, hopefully long-term capital gains income at that point, and you don't have to do anything. It's all of the work of compounding without any of the actual effort.

Nadig: And you're not going to have to do any – you're not going to get any short-term capital gains from the internal trading?

Morris: No short-term capital gains because we use the heartbeat trade mechanisms. And, you know, although they're passive products, they're deeply and actively engaged products. These are, it's engaged management, but not necessarily active management in that sense.

Nadig: Right, you're not making a call that, “We want to be more in the five year today!”

Morris: No, exactly. It's, we follow – there's an index. We built the index, not because we needed it. We had NASDAQ build the index for us because we wanted to show folks this was a mechanical process that could be done over time with an independent adjudicator of all the results that could show you here's the actual results.

Nadig: I'm hearing from advisors, I mean, I was joking with Brent Sullivan, who runs tax Alpha Insider, that this is hot tax summer because it seems like all summer long most of the ETF industry was focused on taxes one way or another. Sometimes good, sometimes bad. We had, you know, lots of return of capital products in the income space that I think confused a lot of advisors. We've had legitimate return of capital type products in the MLP space. We've had lots of people talking about tax aware long/short. How does your approach fit in with all of these other things advisors are getting beaten up with about how to manage their clients' taxes?

Morris: So, Brent does a great job. Folks haven't followed him, they should. And Brent came from Parametric, which is like the OG tax manager. So, you know the knowledge is good. I think unlike some of those which are trying to take advantage of either some underlying security value or recharacterize something using something sophisticated, this does the opposite and just does the simplest thing possible. And it started not because we wanted to manage taxes at all. Started because we had institutional investors who told us, "We will sell your product if you go to weekly dividends."

We were going to move TBIL to weekly dividends because we thought folks wanted more cash faster. And many did, except institutions who don't have drip programs and have to reinvest, or folks who have drip programs who told us, "You know, the reinvestment it’s pretty poor quality. Doesn't happen when we want, can you… please don't do that." And we never thought about it. We just said, "Well, sure you want your money faster." That seems more honest. "Let's give the money to you, you choose whether you want us to keep your money. Why should we hold on to it for a longer period of time?"

Turns out the market absolutely didn't want that. So, we were building a version of TBIL that would never pay a dividend in an effort to just help people operationally who wanted to compound their money. Then we realized working with some folks who started the BulletShares products, David Cohen and his team, that, “Wait a second, there's this great tax benefit.” Because they’d been thinking about it purely from that side. And it was like chocolate and peanut butter when now the sort of intel inside that needs to happen to run that in a zero slippage or the least slippage way possible meets this whole new audience of users, right?

And U.S. taxpayers have benefited because you're going to take ordinary income that happens at a time and place of the ETF issuer and the government's choosing and turn it into income, long-term capital gains income at a time and place of your choosing. Offsettable, which is great. Income not other than $3,000 a year, but something else really interesting kind of happens of all this. You don't have to do anything, which is great because I don't have all the time in the world to do this, and I do this professionally. Like, my PA is the last account to get looked after. Things don't get invested all the time. Cash sits where it shouldn't. We know that happens everywhere. And we now give you the freedom to take the asset allocation you want, put it wherever you want to put it, as opposed to sitting there with three spreadsheets and some goldenrod paper and working out this game of Tetris of, “I’ve got this thing over here,” or “I can't sell that because I'm going to get this” or, “What do I do?” Let's just eliminate all that.

Where Compoundr Makes Sense and What's Ahead

Nadig: So, in other jurisdictions outside the U.S., there are their actual structures that are sort of accumulating shares versus distributing shares. And in those in those environments, pretty much every asset class has versions of those. Where do you think this doesn't work? Like, where wouldn't you take this out to the Street with a new idea? You guys are predominantly pretty “stick to your knitting” bond shop, but does this not apply in emerging market equities or or, you know, options writing strategies? How far could you push this idea of using the timing and the mechanism of your trading to effectively never have to make distributions?

Morris: So, there are some areas where it might work, it just would have less efficiency to it. The S&P 500 is pretty tax efficient. They're qualified dividends, so you might pick up the timing function, but you're not going to get a lot of inherent arb. Unless, of course, you're a non-U.S. domicile investor, right? Non-resident aliens who pay the 30% holdback tax, they're immediately benefiting because there's that 30% they don't pay. So, they're worried about their local jurisdiction. So, if you're in that camp, right – this is a great trade for you, even if you're in securities that have lower or other tax advantage.

Certain parts of the REIT market have lots of tax advantages built into the REIT itself. Same with the MLP space, where there's just benefits of return of capital that, although you can compound the income, you do actually want that because it's some flow through to your ultimate 1040 that you want to see. I think there are… it works everywhere. There's just places where it works better. And the better area, anything where a lot of your return is cash.

Nadig: And right now, what do you guys have launched?

Morris: We have the Agg, CPAG, and high yield, CPHY. You're going to see us come to market with some cash products, so tackling the cash space for folks who don't like the way some of the options products work, who think they flirt a little too closely with some of the IRS anti-avoidance rules. And then you'll see us go pretty hard into these other cash spaces. So, BDCs, REITs, high div paying stocks, things that are just for whatever reason a little clunky. A lot of preferreds that are clunkier there in that bond hybrid equity space as well. So, it feels like they're a good marriage for this where liquidity is weird and having scale in one place would be great. So, a lot of cool things like that to come out.

But I think the key for most investors are, we want to make this simple. There are a lot more academically pleasing ways that you could try to achieve this. Folks have done this through crystallization strategies for a long time with futures and all that.

Nadig: Lots of note strategies, yeah.

Morris: You could go buy an IOVA. There are a lot of things you could do. The question is, though, is it worth the upkeep? And how do you just distill this to the simple versus just buying the ticker? Just buy the ticker and make sure what's in the ticker, you do some diligence. The reason why we built the index is so we could show you this is actually how it works. You can see historically all of the trades that would have been made based on simple market metrics and decide is that right for you? Because the problem with those really complicated ones are, they're always getting more complicated. You don’t have to be complicated to be powerful.

Nadig: Boy, this industry certainly seems to try to prove that wrong everyday.

Morris: That’s like politics, right? Politicians complain government doesn’t work, then they get elected…

Nadig: And then government doesn’t work. Thanks for joining us.

Morris: Thank you, sir.

Nadig: Cheers.