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July 15, 2019 at 05:06 PM
The fast-growing U.S. ETF market could be transformed by major changes coming over the next few years, ranging from regulatory changes that would expand the market to potential tax changes that would restrict it. Here are six key areas to watch.
1. The Debut of Non-Transparent Actively Managed ETFs
Before year-end, the first non-transparent actively managed ETFs are expected to come to market, according to Daniel McCabe, CEO of Precidian Investments, which developed the strategy that allows ETFs to conceal holdings from investors for months at a time. The Securities and Exchange Commission approved the strategy in April.
To date, 10 large asset managers have licensed the strategy, called ActiveShares, including American Century, Capital Group, JPMorgan, Gabelli, Nationwide, Nuveen and Legg Mason, which holds a minority stake in Precidian Investments. In addition, Precidian is working on contracts with close to 30 other firms, which it expects to close shortly, McCabe tells ThinkAdvisor.
The ETFs include U.S. equities, ADRs, U.S.-listed futures, Treasuries and bond ETFs and REITs, says McCabe.
(Related: SEC Gives Final Nod to First Nontransparent ETF Strategy)
A recent Cerulli Associates survey of “product heads” from 35 asset managers found that that 46% indicated they would build nontransparent ETF capabilities within a year following SEC approval of Precidian’s ActiveShares proposal.
Douglas Yones, head of exchange-traded products at the NYSE, says the introduction of nontransparent active ETFs could prove to be a “watershed moment” for the ETF industry, leading to an explosion of AUM above the almost $4 trillion that traditional transparent ETFs hold today. Yones and McCabe were among the panelists at a recent event sponsored by Gabelli Asset Management in New York.
2. Threats to the Tax Efficiency of ETFs
One of the biggest draws for ETFs is their tax efficiency, but that advantage could be under threat because the more popular ETFs become, the more revenue the U.S. Treasury forfeits as a result.
Unlike mutual funds, ETFs are not required to distribute capital gains to shareholders when their securities are sold for a profit to meet redemptions or free up cash for new investments. When redeeming — and creating — shares, ETFs use in-kind transactions, which are not considered cash transactions and therefore do not result in pass-through capital gains.
Fifty-six percent of passive mutual funds had a taxable capital gain distribution compared with 7.5% of ETFs in 2018, according to Morningstar. State Street’s SPDR S&P 500 ETF (SPY), the first and largest ETF, hasn’t reported a capital gain in 22 years, according to Bloomberg.
Fordham University of Law Professor Jeffrey Colon, who was also a moderator at the Gabelli event, has called for the repeal of Section 852 (b) (6) of the Internal Revenue Code, which allows for the tax-free distribution of capital gains in ETFs and in mutual funds. He labels the taxation of in-kind ETF redemptions “the great ETF tax swindle.”
That section of the tax code dates back to 1969, before ETFs existed, but it was rarely used by mutual funds because shareholders preferred to be paid for redemptions in cash. That’s not been the case for ETFs, which regularly use in-kind redemptions and share creation.
3. Heartbeat Trades at Risk?
A supersized manifestation of this tax advantage for ETFs is the so-called heartbeat trade, which ETFs use when they need to undertake a large rebalancing. The September 2018 restructuring of the Global Industry Classification Standard (GICS), which created a new communications sector, resulted in many such trades.
(Related: A Massive Shift in Stock Sector Classifications Starts Today)
Technology sector ETFs such as State Street’s Select Sector SPDR (XLK), for example, had to sell Facebook and Google parent Alphabet, which had large embedded capital gains, because they were moving to the new communications sector.
