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6 Big Changes That Could Transform the ETF Market

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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. 

During such big moves, an ETF portfolio manager will arrange with a big bank to make large purchases of shares in kind, then quickly withdraw shares, swapping out those with the biggest capital gains. Since no cash is exchanged, the ETF can avoid capital gains on the trade.

Robert Gordon, president of Twenty-First Securities, likened such trades to Section 852 (b) (96) “run amok” at the Gabelli event. 

4. Vanguard’s Innovative Patent Expires in 2023

Vanguard has figured out a way for its mutual funds to use heartbeat trades to minimize capital gains. It created a patent that essentially marries a mutual fund to a similar ETF via an ETF share class for the mutual fund, allowing the mutual fund to siphon off appreciated stock without incurring taxes.

Vanguard has conducted almost $130 billion worth of heartbeat trades since 2004, more than any other fund company, according to Bloomberg. Its patent is due to expire in 2023, which opens the door for more asset managers to adopt similar strategies, provided the IRS doesn’t object. 

Heartbeat trades and ETF tax deferrals are perfectly legal under current law, which predates the formation of the first ETF in 1993, but that could change if the U.S. Treasury decides to collect  more tax revenues to offset exploding debt levels. 

Since 2000, ETFs have undertaken over 2,200 heartbeat trades worth $300 billion, according to Zachary Mider of Bloomberg News, who moderated a panel on the subject at the Gabelli-sponsored event. 

Gordon said that heartbeat trades “smack of prearranged transactions,” which is a violation of securities law.

5. SEC Rule Will Accelerate Market Entry of New ETFs 

Well before the Vanguard patent marrying mutual funds with ETFs expires in 2023 and probably years before there is any change in the tax treatment of ETFs, the SEC expects to finalize a rule that would hasten the entry of new ETFs into the market.

The SEC has proposed a new rule under the Investment Company Act of 1940 that allows both indexed and actively traded ETFs to come to market without the expense and delay of applying for individual exemptive relief so long as the ETFs meet certain conditions. 

These include disclosure of certain information on their websites, including historical information regarding premiums and discounts and bid-ask spread information; certain recordkeeping requirements; and written policies and procedures if the ETF uses custom, rather than pro rata, baskets for securities.

The proposal, known as Rule 6c-11,  would not cover so-called share-class ETFs, such as those run by Vanguard that are structured as a separate class of a mutual fund, nor inverse or leveraged ETFs. 

(Related: SEC Plans to Finalize ETF, Fund of Funds Rules in 2019: IM Chief)

Dalia Blass, director of the SEC’s Division of Investment Management, has said the SEC plans to finalize the ETF rule, as well as a proposed fund-of-fund rule this year.

6. Some ETFs Will Be Moving from NYSE’s Electronic Platform to the Exchange Floor

Another important change for ETFs is the NYSE’s pending plan to list some ETFs on the exchange floor, transferring them from the NYSE Arca electronic platform. On the floor,  Designated Market Makers’ (DMMs) will be responsible to maintain fair and orderly markets, much like they oversee stock trades.

“The DMM model is better suited to providing the type of liquidity needed during the opening and closing auctions each day, said Yones at the Gabelli event, adding that ETFs currently account for about one-third of the daily trading volume on the NYSE.