Deferral, Not Avoidance
ETF investors have one advantage in this example—they have deferred tax payments. While they owe the IRS the same dollar amount, ETF investors pay at the end, while mutual fund investors pay as they go. Tax deferral is advantageous to investors because a dollar tomorrow is generally worth less than a dollar today. That is why Mider and company characterized the tax benefit of heartbeats as “a no-interest loan from the U.S. Treasury to ETF investors.”
Sometimes it’s more valuable than that, because of basis resets that remove capital gains liability upon an investor’s death. Also, many investors’ tax brackets drop after they stop drawing a paycheck. In those cases, the U.S. Treasury simply loses out.
This is why the question of deferred taxation is at the heart of heartbeat fairness. Dollars not received by the U.S. Treasury today cannot supply classrooms, support public health, promote national security or tend to our veterans. Those same dollars do less tomorrow.
Heartbeats Vs. Routine Flows
It is important to remember that not all ETF tax deferral is attributable to heartbeat trades. Mider et al. explain, “The disclosures don’t show how much of [disclosed realized gains from in-kind redemptions] is from the funds’ routine use of the ETF loophole and how much is from special heartbeat trades that maximize the benefit.”
“Routine use” means day-to-day creation/redemption activity that supports the ETF arbitrage process that, in turn, keeps ETF prices aligned with intraday NAVs. Natural order flow—that is, investor buy and sell orders—drives routine creations and redemptions.
Heartbeats are different, because the players aren’t ordinary investors. As Mider et al. confirmed, they are a cooperative set of investment professionals; namely, ETF asset managers and investment banks. Heartbeat trades’ purpose is not to meet public demand for ETF shares, but to facilitate a frictionless, tax-deferring portfolio rebalance.
Heartbeat trades make the year-by-year tax consequences of holding a fund such as the Direxion All Cap Insider Sentiment Shares (KNOW), which turned over 912% of its portfolio between May 2017 and May 2018, equivalent to those of vanilla total market funds like the iShares Dow Jones U.S. ETF (IYY), which turned over less than 4% of its portfolio during the same time frame.
Spirit Of The Law
While heartbeat trades seem to be on solid legal footing in the technical sense, it is fair to ask if they have strayed from the spirit of the law that governs them.
Routine creations/redemptions originate with shareholder activity. While portfolio managers take advantage of routine redemptions to offload low-basis stocks, a routine redemption’s main purpose is to satisfy investor demand for fund shares.
Heartbeat trades, initiated at the behest of the portfolio manager, serve three goals: minimizing tracking error, avoiding block trades, and washing out low-basis stock positions.
The first two objectives can be achieved by placing a market-on-close order with a broker-dealer. The tax management piece cannot. In the heartbeat trade that I took apart, the outgoing securities were split into two groups: appreciated securities went into the redemption basket, while depreciated securities were sold outright via a broker-dealer.
Simply put, there are other ways to achieve perfect index tracking and market-distorting block trades. Only heartbeats make tax deferral possible.
Perhaps this explains why Robert Gordon, president and CEO at Twenty-First Securities, opined: “This has gone too far, and I’m afraid it’s going to be the straw that breaks the camel’s back.”
At the time of writing, the author held no positions in the securities mentioned. Elisabeth Kashner is director of ETF research and analytics for FactSet. Check out Elisabeth Kashner’s new e-book, “Uncover The Key To ETF Tax Efficiency.”