Asset flows in and out of ETFs are going wild, but investors probably shouldn’t read too much into that.
Last week, ETF.com reported that $44.7 billion of new money entered U.S.-listed ETFs during the week ending Thursday, March 15—the largest haul for any week in history.
Then earlier this week, the latest data from FactSet showed that nearly $20 billion exited ETFs on Monday, March 19.
At first glance, these turbulent swings in ETF flows suggest investors can’t make up their minds about how they feel about the markets, but a deeper look at the numbers reveals that something much more benign is going on.
Big Inflows, Big Outflows
The trio had combined inflows of $7.8 billion last week. On Monday, those inflows were completely erased when the three had outflows of $8 billion.
The perfectly mirrored inflows and outflows likely have nothing to do with investors’ appetite for dividend ETFs per se, but they are no coincidence. Rather, they are an attempt by fund managers to minimize capital gains distributions and maximize tax efficiency.
As outlined in an excellent piece by Elisabeth Kashner, director of ETF research and analytics for FactSet, large inflows that reverse a few days later help fund managers wash out capital gains from low-basis stock positions.
Avoiding Capital Gains
As Kashner explains, most exchange-traded funds don’t realize much in the way of capital gains thanks to the secret sauce of the ETF structure—the creation/redemption mechanism.
“ETFs largely avoid passing on [capital gains] using two methods,” she said. “First, most ETFs create and redeem shares in kind. This allows portfolio managers to pass low-basis positions out of the portfolio without selling them. No sale, no realized gain, no tax. Second, many ETFs track low-turnover indexes, so ETF portfolio managers seldom need to realize gains in a rebalance.”
That said, certain ETFs are at risk of large capital gains distributions. According to Kashner, funds that have low-redemption activity and high portfolio turnover are the most likely to be in that category.
Without a steady stream of day-to-day redemption activity to wash out low-basis positions from the fund, come rebalance time—when large amounts of stocks are bought and sold—these ETFs could realize hefty capital gains.
Fortunately, there’s a process that helps ETFs short-circuit that undesirable scenario.
According to Kashner, the process is as follows: “Behind the scenes, someone provides short-term capital to fund share creations in ETFs slated to rebalance their portfolios. The capital is required for less than a week, and often for just one to three business days. The capital can be returned as soon as those shares are redeemed. This short-term access to capital allows ETF portfolio managers to essentially manufacture redemptions that wash out capital gains that would otherwise be realized in a rebalance.”
This is likely what happened with the three aforementioned dividend ETFs. Temporary ETF share creations were reflected as big inflows. Then days later, when the ETF rebalanced, those same shares were redeemed, allowing the fund to get rid of its low-basis stock positions without realizing capital gains, while registering as large outflows from the ETF.
Kashner says this pattern is quite common in the ETF industry. The pattern is repeated “at nearly every large ETF issuer, and many smaller ones, sometimes for nearly every fund and sometimes used quite selectively,” she said, while adding she observed the greatest incidence in smart-beta, equal-weighted and active ETFs.
In the end, these outsized flows don’t say so much about what investors are doing, but what issuers are doing to manage capital gains.
“Bottom line, if you’re looking for effective tax management in an ETF, look at the flows chart. If the chart looks like an EKG, your funds are likely in good shape, thanks to the behind-the-scenes heartbeat of well-timed creations and redemptions,” Kashner concluded.
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