The fast-growing U.S. ETF market could be transformed by major changes in the next few years. 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.
A recent Cerulli Associates survey of 35 asset managers found that that 46% indicated they would build nontransparent ETF capabilities.
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.
2. Threats to the Tax Efficiency of ETFs
The ETF tax efficiency advantage could end 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.
Fordham University of Law Professor Jeffrey Colon 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.”
3. Heartbeat Trades at Risk?
A supersized manifestation of this ETF tax advantage 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.
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. Because no cash is exchanged, the ETF can avoid capital gains on the trade.
4. Vanguard’s Innovative Patent Expires in 2023
Vanguard has figured 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. This allows the mutual fund to siphon off appreciated stock without incurring taxes.
Vanguard has conducted almost $130 billion worth of heartbeat trades since 2004, according to Bloomberg. Its patent is due to expire in 2023, which opens the door for more asset managers to adopt similar strategies,.
5. SEC Rule Will Accelerate Market Entry of New ETFs
The SEC has proposed a new rule 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 such as disclosure of certain information on their websites.
6. Some ETFs Will Move from NYSE’s Electronic Platform to Exchange Floor
The NYSE’s is planning to list some ETFs on the exchange floor, transferring them from the NYSE Arca electronic platform. ETFs currently account for about one-third of the daily trading volume on the NYSE.