(in)KIND ETF Tax Treatment

For all the research and analysis behind a portfolio managers’ insight, their main focus, for the most part, is to provide investment opportunities for clients via their end products.  These portfolio managers along with numerous do-it-yourself investors continuously put forth tremendous efforts with the belief (and hope) that their hard work will provide them with notable appreciation on their investments.  The catch-22 here is that the more you earn the greater the potential taxable event.  Any transaction that results in taxes owed to a government entity is deemed a taxable event and can keep investors and portfolio managers up at night.  The most common taxable event scenarios we encounter include receiving dividends and interest or selling a stock for a gain.  So how does one maximize their appreciation on an investment while also minimizing their potential tax burden? One method could be to hire a competent fund or tax account, whose expertise focuses on tax-efficient strategies.  A second, more cost-effective option could be to invest in products that are deemed more tax efficient.  Exchange Traded Funds have frequently been touted as more tax efficient than their comparable brethren, the mutual fund.  But what exactly does it mean to be more tax efficient and how do the mechanics work?  We at Strategas, believe we have created two new products which will provide the normal tax efficiencies of the aforementioned exchange traded fund (ETF), while adding an additional level of consideration.  Let’s first explore the two main reasons ETFs are believed to be so tax efficient.

The First Benefit - Cashing out concern

For most investors, the realization that ETFs are more tax efficient than mutual funds (in terms of creation and redemptions) is not a new concept.  If an investor owns a mutual fund and decides to redeem the investment, the mutual fund must sell securities to raise cash to meet the redemption request. The resulting transaction, should it create a capital gain, would then cause all those invest in the mutual fund to be responsible for that tax liability.   If this redemption transaction results in a capital gain, the tax liability would be shared by all mutual fund investors.  This means that even investors who did not sell shares would be burdened by the capital gains tax.  On the other hand, with ETFs, when an investor redeems their shares, they can simply sell them in the open market.  This transaction, while a taxable event to the investor who is cashing out, would not impact other investors who opted to hold their security.  But what happens when the Authorized Participant (AP) needs to reduce the number of outstanding ETF shares in the market?  This is an additional tax efficiency of ETF investments.  In this scenario, the AP and the ETF issuer can simply do an “in kind” redemption whereby the issuer simply provides the underlying holdings for the ETF basket in exchange for ETF shares.  Because there has not been a sale or taxable event, there are no capital gain implications. 

The Second Benefit - The Custom Creation Around a Rebalance

In the Fall of 2019, the Securities and Exchange Commission (SEC) passed Rule 6c-11.  This ruling, more commonly known as the ETF Rule, lowered the barrier of entry for new and smaller issuers.  But that wasn’t the only benefit to this rule.  The ETF Rule also allowed the use of custom baskets for creations and redemptions that may differ from the underlying portfolio.  These new custom baskets must be in the best interests of investors. The use of these baskets has provided an extra benefit when trying to manage against capital gain distributions.  In fact, many of our investors often ask us how we manage capital gains when rebalancing our portfolio.  Well, we are fortunate enough to have partnered with Vident Investment Advisory, LLC.  Our sub-adviser’s tax expertise related to these custom creation units in an invaluable partnership that looks to achieve both investing and tax planning goals.  

One might question how the use of custom baskets helps mitigate capital gains?  The best way to describe this is with the following diagram provided by our experts at Vident.  Let’s start with the assumption that an ETF has been created with a standard or initial creation unit and has been trading for in the open marekt.  Next, let’s assume that the portfolio manager (PM) communicates with their sub-adviser that they are looking to change a portion of the underlying constituents via a rebalance.  The sub-adviser then takes the following steps to help mitigate the capital gains consequences via the use of a custom creation unit as noted below.

Portfolio managers also have the benefit of utilizing unrealized losses within the redemption process by marking those securities with losses as “cash in lieu” in their portfolio files. This will enable a portfolio manager to record those losses on the books to offset any future gains that may have (or will) occur, which can also be an advantageous tax strategy.

Tax Efficiency via In-Fund Thematic Rotation

Most of the 250 thematic ETFs we found on Bloomberg are of the single theme variety - disruptive innovation, inflation, or environmental impact.  There is even an ETF that tracks a natural disaster recovery index.  Therefore, while these funds could be very well run and true to their mandate, investors will still have to decide if the impact of a particular theme wanes over time. For example, do we sell our holdings in the open market in order to switch to a new investment - possibly creating a taxable event?  Or do we hold on to the product even though the underlying theme is losing momentum?  We believe our thematic rotation within the funds themselves provides a third element of tax efficiency other funds simply cannot provide due to their investment objective. Backstopped by our team of Institutional Investor ranked analysts, each of our ETFs has a component whereby we rotate in and out of themes over time as: 1) existing themes mature into new or revised themes, e.g. “Work From Home” moves to “Pent-Up Demand for Travel”; 2) themes age out with no natural related successor; or 3) an existing theme loses momentum relative to a new, more impactful theme.  We believe this element of thematic rotation can provide an added layer of tax efficiency as investors need not trade in and out ETFs in order to rotate into a new theme present in the market.

Our Strategas Global Policy Opportunities ETF (Ticker SAGP) is derived from the belief that corporate lobbying can produce positive benefits through successful policy outcomes.   An active ETF, SAGP uses publicly available lobbying data to consider investments in both domestic and international companies potentially set to benefit from periods of intense lobbying of the U.S. federal government.  The result is a politically agnostic portfolio leveraged to successful public policy outcomes which naturally shifts over time as new parties come into power and agendas adjust.  As the constituents change based on their lobbying intensity, so do the underlying themes these lobbying efforts represent.  It is this automatic thematic rotation that helps the fund stay relevant with respect to the policy issues corporations feel are the most impactful on the business landscape.

Our second product, the Strategas Macro Thematic Opportunities ETF (Ticker SAMT) is also an actively managed fund built around the underlying themes which our research-driven approach gives us the highest conviction in.  The fund invests in three to five macro themes at any given time based on analysis prepared by our firm’s research team which is documented and readily available.  Our thematic positioning is adjusted based on shifts in macro trends to ensure both the integrity of each theme’s investment thesis and the relevancy of its constituents.  Once a theme is deemed to lose momentum or another theme comes along that we believe has a better investable conclusion, we rotate out of one theme into another.  Again, we believe it is this thematic rotation that provides an added benefit and limits an investor’s need to sell an entire ETF when a current theme loses momentum which may occur in single-themed ETF scenarios.

Any investment an individual adds to their portfolio should be viewed in a holistic manner with respect to their analysis and underlying holdings.  That said, we believe our two exchange traded products provide an extra benefit with respect to tax treatment that could be extremely advantageous when considering your investment options.