ETF Tax Efficiency Gets Boost

ETFs were already a more tax-efficient mousetrap than mutual funds, but they've just gotten even more tax efficient, due to newly implemented changes in the way creation/redemption trades are processed and settled.

As a response to the adoption of Rule 6c-11, better known as the "ETF Rule," the National Securities Clearing Corp. (NSCC) has begun implementing several changes meant to streamline and enhance its settlement procedures, including the publication of pricing baskets and the extension of creation/redemption settlement time frames. (Read: "SEC Passes Landmark 'ETF Rule'”)

A subsidiary of the Depository Trust & Clearing Corp. (DTCC), the NSCC handles the back-end plumbing of ETF trades, including the ordering, clearing and settlement of "in kind" trades (i.e., the exchange of ETF shares for shares of the underlying, and vice versa).

These in-kind trades are the secret sauce that make ETFs so tax efficient. With the NSCC's new policies, however, they're about to get even easier to implement.

"The newly created flexibility for customization and pricing help keep spreads in check and the ETF ecosystem healthy," Bill Kapogiannis, executive director for the DTCC's Equity Clearing Product Management Group, told ETF.com.

ETF Creation/Redemption Refresher

To put in context why these changes matter, let's first start with a refresher on ETF creation/redemption.

Whenever an ETF issuer wants to create new shares of its fund or remove existing shares from the market, it turns to a special market maker known as an "authorized participant" (AP). (Read: "Who Are Authorized Participants?")

APs have special permission from the issuers to create and redeem ETF shares, which they do in large chunks of shares known as "creation units."

To make new ETF shares, APs buy up a "basket" of the underlying securities in the fund's index and deliver them to the issuer, who then gives them a creation unit's worth of ETF shares in an in-kind exchange. The process also works in reverse: APs can submit a creation unit's worth of ETF shares, and receive a basket of the underlying securities in exchange.

To know which securities to submit (or which they'll receive) and in what amounts, APs rely on a list of securities known as the portfolio composition file (PCF), which is updated daily.

The securities published in the PCF are known as the "trading basket," and their aggregate value (plus any cash amount necessary) is equal to that of the net asset value (NAV) of the ETF's creation unit. That way, the trading basket can be swapped one-for-one for ETF shares, and vice versa.

ETF Custom Baskets

There are two types of trading baskets: standard and custom. Standard baskets are probably what you'd expect: a simple, pro rata slice of the ETF's portfolio—meaning, a proportional slice of all the securities represented by the ETF's index.

Anything that isn't a pro rata slice qualifies as a custom basket: a collection of securities in nonrepresentative amounts, maybe, or perhaps a list that includes cash or other securities in place of some or all of the ETF's constituents.

Not having to produce an exact, proportional slice of a portfolio gives APs greater flexibility to make a trade that's more cost effective for them, which in turn can narrow spreads for investors in the secondary market. That's also pretty useful for ETF issuers, which can use custom baskets to minimize the capital gains impact from higher-turnover strategies—again, which benefits end-investors.

However, the SEC had stopped allowing custom baskets in exemptive reliefs in 2012, meaning only some of the issuers in the ETF industry had been granted permission to use them. That gave legacy players a leg up on the competition, allowing them to post tighter spreads and save more money than newer issuers who couldn't use custom baskets.

When the ETF Rule passed, though, it explicitly opened up custom baskets for use by any issuer, no matter how new to the market they were. (More on why that matters in a moment.)

Why ETF Pricing Baskets Matter

However, trading baskets aren't the only type of securities basket used by APs. Issuers also often provide them a "pricing basket," which reflects the value of the ETF's entire lineup of portfolio constituents—including futures, options, swaps, fractional shares, and more.

Whereas a trading basket might have some cash holdings in it, or securities in nonrepresentative amounts, the pricing basket is a snapshot of literally everything an ETF holds. As such, it's not the most useful basket for APs looking to engage in creation/redemption (especially when it comes to enormous portfolios holding thousands of securities).

Instead, pricing baskets are meant to be used as a means to value an ETF's portfolio throughout the trading day. That in turn allows APs to spot disconnects that may arise between an ETF's price and its NAV. Those premiums and discounts to NAV present juicy arbitrage opportunities for APs. They then use trading baskets to create or redeem ETF shares and turn some profit—which in turn helps push an ETF's NAV back in line with its price.

NSCC To Start Publishing ETF Baskets

Unlike tracking baskets, the NSCC typically hasn't published pricing baskets; instead, APs must source them elsewhere—usually from third-party vendors or the ETF issuers themselves; or, if they're not available, then via the daily holdings list on an ETF's website (which the ETF Rule also now requires).

This isn't the most efficient process. It would be much easier and faster for APs to just get their trading baskets and pricing baskets in a single, consolidated and standardized file.

That's exactly what they'll be able to do now. The NSCC will publish a number of basket types, including standard, pricing, restricted, rebalance, creation/redemption-only and negotiated.

"Enhancing the PCF to differentiate pricing baskets from trading baskets reduces risk for both NSCC and its members," said Murray Pozmanter, DTCC managing director and head of Clearing Agency Services, in the release announcing the change.

"This will simplify clients' means of obtaining this information at a fair cost," added the DTCC’s Kapogiannis.

Heartbeat Trades Lower ETF Costs

The NSCC's other change is subtle, but it has significant implications for what's known as "heartbeat trades," or large rebalance trades, often implemented due to a change in the ETF's underlying index.

We've written about heartbeat trades aplenty—in fact, we were one of the first media outlets to report on them when they showed up in fund flows. They're a core reason ETFs don't incur huge capital gains upon rebalancing or reconstitutions. (Read: "The Heartbeat Of Tax Efficiency.")

Here's how it works: When an ETF's underlying index rebalances, dropping some constituents or adding others, the ETF needs to do the same by buying some securities and ridding itself of others. Securities that have depreciated in value can be sold for a profit, but selling securities that have grown in value would incur a capital gain.

Fancy Financial Footwork

To address this, ETFs engage in some fancy footwork with APs using the aforementioned custom baskets.

An AP, who knows a rebalance is coming, submits a creation order to the ETF—meaning, they'll provide the underlying stocks and get ETF shares in-kind—but they'll do so using a custom creation basket that possesses the new securities that were just added to the index. Then the AP takes a short position in the securities that need to be removed from the ETF's portfolio.

Almost immediately afterward, the AP files a custom redemption order, one that will exchange the newly created ETF shares for a basket of the underlying stocks, which will contain within it the old constituent stocks that the ETF wants to offload. Once the order goes through, the AP's short positions are zeroed out by the longs that they just accepted.

Through this process, the ETF gets the new securities it needs and rids itself of the old ones, without having to sell anything and incur a capital gain. Meanwhile, the AP gets to profit on the difference between the ETF's NAV price and the day's closing price. (Read: "The Players Behind ETF Tax Efficiency.")

The ability to pull off one of these heartbeat trades depends on the use of custom creation and redemption baskets—which is yet another reason it was so important that the ETF Rule made custom baskets available to all. Now everyone can take advantage of the same tax-saving process.

A More Efficient Heartbeat Trade

To effect one of these heartbeat trades, APs usually take care to line up the settlement dates of their creation/redemption orders to minimize any overnight positions (and associated margin). At the same time, for tax reasons, APs also prefer to hold the newly created ETF shares for at least one day before a redemption order is settled.

"Due to an IRS loophole, it allows for more capital gains exclusions when the agent/sponsor holds the underlying components for three days on the redeem side," said Kapogiannis.

So the NSCC has updated its rules to allow more flexibility in the timing of order settlement, such that APs can pick their settlement dates for creation/redemption orders beyond just T+1 (one day) or T+2 (two days). That way, APs can still take advantage of this heartbeat trade, while pushing out their redemption date as needed to the most favorable spot.

Plumbing That Works

While these changes may seem “inside baseball,” the end result is a creation/redemption process that functions more smoothly. That in turn should result in tighter spreads for the end-investor, even for actively managed ETFs and other ETFs that couldn't use custom baskets until the ETF Rule allowed it.

Plumbing that works is important, and ETFs already had better plumbing than the competition. Now the water in the pipes is going to flow even better.

Contact Lara Crigger at [email protected]