A strange "heartbeat" pattern has emerged in the flows data for the second-largest technology ETF on the market, the $22 billion Vanguard Information Technology ETF (VGT), but investors shouldn't be alarmed.
Rather than evidence of panic selling and buying in the tech sector, this unusual pattern actually represents Vanguard's positioning in advance of industrywide sector classification changes scheduled to go into effect on Sept. 28 (read: "Changes Ahead For 24 Sector ETFs").
Since May 8, roughly equal amounts of money have flowed in and out of VGT each week, with the flows often separated by a single day. The quantity of money changing hands is sizable, ranging from $250 million to $400 million at a time:
A similar pattern has emerged in the $3 billion Vanguard Consumer Discretionary ETF (VCR), though the quantity of money moving in and out of the fund is an order of magnitude smaller, between $5 million and $20 million:
Chart Sources: ETF.com, Factset; data as of July 31, 2018
No other Vanguard ETFs appear to demonstrate this weekly heartbeat pattern over the same time period.
At first glance, it might seem Vanguard is up to some clever portfolio management, deftly balancing large investors who wish to enter and exit two funds whose sectors have seen higher volatility as of late.
But given the timing of the flows—they first began at the beginning of May—and the fact that the pattern only appears in these two funds, another explanation is more likely.
Sector Changes Coming
As we've covered recently, VGT and VCR are two of three Vanguard ETFs impacted by this year's change in the Global Industry Classification Standard (GICS), which will change the classifications for thousands of global stocks.
As a result of this change, several FANG-style internet companies and media stocks will move to the former telecommunications services sector, which will be renamed communications services. Meanwhile, many e-commerce stocks will be moving from information technology and into the consumer discretionary sector.
Curiously, the Vanguard Communications Services ETF (VOX)—formerly the Vanguard Telecommunications Services ETF—is also impacted by the GICS change, but does not show the same heartbeat pattern in its flows as VGT and VCR. But there's a good reason for that, too.
Why Heartbeat Appears
Elisabeth Kashner, director of research and analytics for FactSet, first uncovered the appearance of the "heartbeat" pattern in ETF flows data, noting that these large, equal-but-opposite flows in and out of an ETF typically showed up around the fund's rebalance dates (read: "The Heartbeat Of Tax Efficiency").
The heartbeat, she theorized, was tell-tale evidence of a trade that allows ETF managers to reduce the significant capital gains that would otherwise result from large rebalance and reconstitution trades.
By using the in-kind redemption process unique to ETFs, wherein fund shares can be swapped for their underlying securities rather than sold, portfolio managers can wash out appreciated, high-tax-burden stock positions and minimize an ETF's overall capital gains.
To do so, an anonymous donor (usually a market maker) provides an injection of short-term capital in advance of rebalance dates to fund share creations. That capital can be returned as soon as those shares are redeemed, usually within the week (read: "The Players Behind ETF Tax Efficiency").
This inflow/outflow pattern most often happens in high-turnover products, such as smart-beta funds and actively managed funds, which can't always find enough opportunities to wash out capital gains through the course of day-to-day trading. But it can also appear when funds experience significant changes to their underlying indexes.
Vanguard's Indexes Change
On May 3, VGT, VCR and VOX all changed their underlying benchmarks to custom transitionary MSCI indexes, in advance of the impending GICS change.
"The transition to the new benchmarks is not expected to result in material capital gains distributions to shareholders," wrote Vanguard in a March press release announcing the index changes.
During the transition, VGT and VCR will lose constituent stocks to the new communications services sector, tracked by VOX. That means VGT and VCR will need to get rid of relevant stocks, while VOX will need to acquire them.
A good way to avoid realizing capital gains in VGT and VCR, then, would be for Vanguard to use the special ETF redemption process to swap out, rather than sell, those stocks whose classifications are changing. If that trade were made, then a heartbeat pattern should show up in the flows data for both VGT and VCR—just as we have seen.
VOX, meanwhile, can simply purchase the new stocks as needed, or use in-kind creations in much the same way. No heartbeat pattern should show up in its flows data, and indeed, none exists.
The evidence suggests, then, that the heartbeat pattern that has emerged in VGT and VCR's flows data since May is Vanguard's way of minimizing capital gains as those funds make a sector transition that will affect upward of 15% of the stocks in VGT and 12% of the stocks in VCR.
Hidden Costs To The Heartbeat
Yet there is one caveat to all this: Trading activities around rebalancing are not free, as Kashner found. The expense of rebalancing adds up, resulting in a cost passed on to investors that, in some cases, can be equivalent to a substantial portion of the fund's usual annual expenses.
In any rebalance trade, Kashner said in an email statement to ETF.com, there will be winners and there will be losers.
"Winners include investors in taxable accounts, who avoid capital gains, including all share classes that jointly own the portfolios of VGT and VCR. Market makers and the broker-dealer who works the trade are also winners,” she said.
"Losers include investors in tax-sheltered accounts. Also, all shareholders lose by the amount that the market makers and broker-dealers win," Kashner added, though this has more to do with timing of a market trade than the heartbeat flow pattern, specifically.
Vanguard declined to comment for this article.
Contact Lara Crigger at [email protected]