On July 11, the Gabelli Organization hosted a unique line-up of industry and legal professionals to address several fundamental issues facing the funds industry today. The conference started by addressing the dynamics around Rule 852(b)(6) and its impact on taxes for investors in mutual funds and exchange traded funds (ETFs). The second panel highlighted Elisabeth Kashner’s research work about “Heartbeat trades” in the ETF marketplace. Lastly, several leading industry professionals convened in an “Active ETF Innovators Panel” to discuss the implications of the recent Precidian “Activeshares” approval in May by the SEC and the strong growth over the past few years of transparent active ETFs. In short summary, the panelists provided a unique forum for understanding some of the dynamics unfolding and how organizations are reacting to the accelerating change.
Conference Agenda
BACKGROUND
The Securities Act of 1933 was the first federal legislation to regulate the stock market, which led to the innovation of investment funds. Since then the industry has seen many important changes including the creation of IRAs in 1974, ETFs in 1993 and most recently changes to the fiduciary standard.
Exhibit 1 Significant Events in Fund History
Source: ICI.
At the end of 2018, the domestic mutual funds industry totaled over $21 trillion, largely dominated by mutual funds.
Table 1 Fund Industry AUM 2018
Source: ICI.
The growth of ETFs has been fairly dramatic over the last decade rising to over $3.4 trillion at the end of 2018. The strong growth has been helped by significant inflows and at the expense of traditional mutual funds. The first ETF, started in 1993 was State Street’s SPDR S&P 500 Trust and now totals over $275 billion.
Exhibit 2 Growth of ETFs
Source: ICI.
Table 2 2018 Fund Flows
Source: ICI.
Rule 852(b)(6)
Some of the growth attributed to ETFs is due to relative tax advantages over mutual funds. Because of structural differences, ETFs are able to take advantage of in-kind redemptions to distribute lower basis tax lots – essentially providing the ETF owner deferred tax treatment such that the investor only pays capital gains taxes when the ETF position is sold. It is estimated by Bloomberg that in 2018 ETF unrealized distributed gains were over $200 billion.
The reason for the tax advantage is related to Rule 852(b)(6), which provides for “exemption from gain recognition for in-kind distributions by mutual funds.” In reality, the rule encompasses the whole mutual fund industry; however, in practicality the ETFs are the vehicles taking advantage of the deferred tax opportunity because of their structure, while mutual funds rarely do so given industry practice and feasibility about redeeming diversified portfolios of securities for smaller retail customers.
The ability to defer capital gains treatment is a major advantage for ETFs especially related to total return over time. In the below example, we provide an illustration of $10 million of invested capital at an 8% compounded annual return for 10-years. For the mutual fund investment we assume a 20% annual capital gains tax is paid, while the ETF retains the capital and eventually pays a 20% tax on the accumulated earnings. (For simplicity, we assume no dividend income or management fee impact). At the end of 10-years, the benefit to the ETF holder is approximately $700,000.
Table 3 Mutual Fund vs. ETF Illustrative Return Example
Source: g.research.
Takeaways From the Conference
Panel #1 – Rule 852(b)(6) – Mutual Fund Taxes vs. ETFs
· Tax mechanisms were originally intended to be an emergency stopgap for mutual fund liquidity and was not really used until ETFs emerged.
· Full agreement that ETFs with their unique structure are able to benefit disproportionately from (b)(6)
· ETFs also provide a number of other factors that may be more desirable to investors including lower costs, real time trading, and market prices that have little tracking error to NAV vs. traditional closed-end funds
Could you change the playing field?
· Change to partnership accounting? When a shareholder redeems, the assets have a carry-over basis. The problem is that partnerships have a lot of complicated rules for assigning gains and losses. In theory, partnership accounting works well, but comes with a lot of complexity. The complexity would come with extra cost. Investors would not welcome K-1s with mutual fund statements.
· Eliminating fund level taxes? Would make mutual funds effectively Roth IRAs and would create big revenue loss for the government.
· Repeal 852(b)(6)? Tax rule applies to all mutual funds – not feasible to think IRS would change rule that already is applied to all vehicles.
Panel #2 – Heartbeat ETF Trades
· Panelist analogy – “Imagine if the IRS gave grocery stores a deduction every time a customer returned a box of cereal. So supermarkets started telling their friends to buy all of their cereal and return it the next day.” Believe ~2,300 heartbeat trades have occurred since 2000. ETF AUM has exploded over the same timeframe.
· Heartbeat trades help defer capital gains for ETF ownership. But if held to death or donated to charity, the tax is never paid because the tax basis is stepped up. And for those that retire with income below ~$78,000, the capital gains rate is 0%.
· Estimated that heartbeat trades cost about 6bps to the fund through trading transactions. This is worth it to avoid the pass through of capital gains. Unfortunately, if the investor is in a tax exempt account, there would be no gains avoidance incentive and the extra trading costs are a negative.
· Heartbeat trades are usually done through custom baskets. Large inflows from the broker/dealer community a few days before reconstitution of the index and then a large redemption. For the major heartbeats the trades can be tracked. However, every day there is optimizing of the holdings due to the normal course of redemptions.
· “To do a heartbeat trade, you must be able to do a custom basket. . . ETFs that received exemptive relief post 2014 must do pro-rata baskets, not custom baskets . . . still small sample of have-nots, of which mostly active managers.”
· Some mutual funds do use in-kind redemptions to facilitate capital gains avoidance. One company, ReFlow offers solutions to help mutual funds currently.
Exhibit 3 Heartbeat Trades
Source: Bloomberg Businessweek, March 29, 2019.
· Vanguard has a unique patent process with ETFs and index mutual funds to minimize capital gains. The patent is set to expire in several years (2023 as quoted by one of the panelists).
Exhibit 4 Vanguard Patent
Source: Bloomberg Businessweek, March 29, 2019.
Source: United States Patent Office.
#3 Panel – Active ETF Innovators – Precidian’s Big Announcement
· Davis Funds decided to launch active ETFs ~3 years ago, with buy and hold and large-cap strategies seeming well aligned for new wrapper – taking a vehicle agnostic approach for clients – offering SMAs, Mutual Funds and ETFs. Solid success so far with ETF AUM at ~$700 million and active trading volumes.
· Transparent active ETFs are growing very quickly. Over $80 billion in AUM across 285 different products. +40% CAGR last few years. Fixed income, especially short duration, is driving demand.
Exhibit 5
($, billions)
Source: ICI.
· Precidian History:
– Began in 2009, spent 2-years in SEC draft
– Then got out of draft, and saw a lot of copy cats filings
– Took 10-years to get through SEC
– Approval in May 2019
– Managers with AUM encompassing 25% of the addressable market have signed licenses
· Different parties are handling the Precidian model differently. Some are converting and some are cloning. The parties that we are speaking to aren’t dipping toes, they are going to use their largest strategies. Some missed the boat on passive so they feel this may be an opportunity to make up ground. Believe there is a $6 trillion actively-managed pool that is the addressable market.
· “Semi-transparent ETFs will be transformational – educational hurdles aren’t really there the way they were with ETFs originally. You might be surprised how fast this could grow.” ETFs are also easier to invest in for foreign investors, which is not being talked about.
· NextShares vs. Precidian “ActiveShares”
– Very innovative on paper, but more challenging with infrastructure – trading, clearing, etc.
– Precidian works like normal ETF – trades through brokers, settles normally etc.
· Pro-rata slicing is critical because it enables more efficient trading and hedging with market makers. Precidian will use pro-rata baskets vs. customized baskets.
· Technology infrastructure lagging innovation? ETFs not broadly supported on retirement platforms. Different requirements for custody etc. However, tone and tenor with major platforms has changed dramatically since May approval. Ability to lower costs to participants is also a big driver of discussion.
· Flash crash issues? Infrastructure and understanding around ETFs has improved “a lot” since the Flash Crash. Liquidity of underlying investments in ETFs is the real concern. Precidian model approved for US listed securities, ADRs and futures – no private investments or foreign ordinary securities. In the future, there may be an expansion of the investment set, but for now, focus is on executing on approved license structure.
I, Macrae Sykes the Research Analyst who prepared this report, hereby certify that the views expressed in this report accurately reflect the analyst’s personal views about the subject companies and their securities. The Research Analyst has not been, is not and will not be receiving direct or indirect compensation for expressing the specific recommendation or view in this report.
Macrae Sykes (914) 921-5398 G.research, LLC 2019
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