Sector Shuffle Not Taxing At All

As sector indexes transition to new classifications, ETF issuers are taking steps to boost funds' tax efficiency.

Today, revisions to the Global Industry Classification Standard (GICS), an industrywide sector classification upon which dozens of ETFs are based, will finally take effect.

These changes, which we've reported on extensively, are the largest such change to the classification standard ever made. As such, dozens of GICS-based ETFs will require significant rebalancing to accurately reflect their benchmarks' new compositions.

Substantial ETF rebalances sometimes can result in hefty capital gains tax events for investors. Fortunately for investors, that isn't likely to happen to here.

The reason is tied to an unusual "heartbeat" pattern that has begun to appear in the daily flows of several of the largest, most popular GICS-linked ETFs—tell-tale evidence of trades made specifically to boost ETF tax efficiency in situations just like this.

Flows Pulse Felt Earlier This Year

In August, we reported an unusual "heartbeat" pattern had emerged in the flows data for two Vanguard ETFs impacted by the GICS changes, including the Vanguard Information Technology ETF (VGT) and the Vanguard Consumer Discretionary ETF (VCR) (read: "Behind Vanguard's "Heartbeat" Flows").

Roughly equal amounts of money had flowed in and out of these two funds each week for several consecutive weeks, with the flows often separated by a single day. The quantity of money changing hands had been sizable, ranging from $250 million to $400 million at a time:

Sources: ETF.com, FactSet; data from Sept. 1 to Sept. 25, 2018

This wasn't the first time such a "heartbeat" had been spotted in an ETF's daily flows data. Elisabeth Kashner, FactSet director of research and analytics, had first uncovered the pattern earlier this year, noting that these large, equal-but-opposite flows in and out of an ETF typically fell around a fund's rebalance date (read: "The Heartbeat Of ETF Tax Efficiency").

As she theorized, the trade allows ETF managers to reduce the capital gains that would otherwise result from large rebalances. By using the in-kind redemption process unique to ETFs, wherein fund shares can be swapped for underlying securities instead of sold (like in a mutual fund), portfolio managers can wash out appreciated, high-tax stock positions and minimize the ETF's overall capital gains.

The process works like this: An anonymous donor (usually a market maker) injects short-term capital in advance of rebalance dates, funding share creations. That capital is then returned days later, as those ETF shares are then redeemed (read: "The Players Behind ETF Tax Efficiency").

That was what Vanguard was doing with VGT and VCR back in June and July, after switching those two ETFs to new transition indexes designed to incorporate the GICS changes gradually. Now it appears that history is repeating itself, as the heartbeat pattern has appeared in several Select Sector SPDR funds right now.

Heartbeat Across Select Sector SPDRs

For example, the pattern is obvious in the Technology Select Sector SPDR Fund (XLK), where $3.3 billion entered the ETF on Sept. 20, only for $3.8 billion to exit on Sept. 24:

Sources: ETF.com, FactSet; data from Sept. 1 to Sept. 25, 2018

The pattern also emerged in the Consumer Discretionary Select Sector SPDR Fund (XLY), where $2.5 billion entered on Sept. 20, and $2.2 billion exited on Sept. 24:

Sources: ETF.com, FactSet; data from Sept. 1 to Sept. 25, 2018

It even showed up in the $142 million SPDR S&P Software & Services ETF (XSW), which saw $31 million enter on Sept. 20, then $27 million exit on Sept. 24:

Sources: ETF.com, FactSet; data from Sept. 1 to Sept. 25, 2018

S&P Transitions Its Indexes

The heartbeat pattern has emerged in these particular funds at this particular moment in time because of rebalancing.

On Sept. 21, the S&P indexes on which the Select Sector SPDR Funds are based were rebalanced to incorporate the new GICS classification revisions. The goal was to be rebalanced by the open of markets on Sept. 24, coincident with the usual quarterly rebalance.

Over the course of several days, tech ETFs based on the former information technology sector had to sell off stocks that would be moving to the new communication services sector. To avoid realizing capital gains during those transactions, State Street used the ETF redemption process to swap, instead of sell, those stocks whose classifications are changing. That heartbeat pattern is the footprint indicating just such a trade occurred.

The new Communication Services Select Sector SPDR Fund (XLC), meanwhile, simply had to purchase new stocks as needed, or use in-kind creations in much the same way. No heartbeat pattern should be expected to show up in XLC's flows data—and indeed, none does:

Sources: ETF.com, FactSet; data from Sept. 1 to Sept. 25, 2018

Since Sept. 1, XLC has taken in $1.01 billion in new investment assets, including $335 million on Sept. 25 alone. Expect these flows to rise as investors continue to transition their portfolios to adapt to the new sector breakdowns.

Why Not Elsewhere?

Intriguingly, the heartbeat pattern hasn't emerged in most iShares products based on the GICS system. The one exception is IXN, which saw inflows of $302 million on Sept. 20, then outflows of $305 million on Sept. 24:

Sources: ETF.com, FactSet; data from Sept. 1 to Sept. 25, 2018

The reason for this is that, apart from IXN, most iShares ETFs based on GICS classifications won't be making huge rebalances at this time.

The iShares Global Telecom ETF (IXP), for example, actually became the iShares Global Comm Services ETF, effective Sept. 24—meaning that it is now a globally focused competitor to XLC. It will need to buy up new stocks rather than sell off old ones (telecom is remaining a division of communication services in the new GICS arrangement), so no in-kind redemption process will be necessary to rebalance its portfolio.

Meanwhile, the iShares North American Tech ETF (IGM) and the iShares North American Tech-Software ETF (IGV) are based on indexes that won't be reconstituted until Dec. 21, according to iShares.

Heartbeats In VGT & VCR Return

And what of Vanguard's VGT and VCR? The heartbeat has made a return to those funds in recent days as well: $66 million flowed into VGT on Sept. 21, only for $65 million to flow out on Sept. 25. Meanwhile, $9 million flowed into VCR on Sept. 21, only for $9 million to flow out on Sept. 25.

Eagle-eyed readers will note that the magnitude of those flows is substantially smaller than the ones we noted back in August. It appears that after all that work earlier this summer, Vanguard only needed to make a few tweaks before its ETFs' transitions were complete.

So for investors in these popular ETFs at least, it looks like the potential for a nasty tax shock as a result of the GICS changes is slim indeed.

Contact Lara Crigger at [email protected]