Tax Efficiency Challenges For Non-Transparent and Semi-Transparent Active ETFs: Are Custom Baskets on the Horizon?

Posted by Jim Kaiser on Sep 29, 2020 10:24:00 PM

Exchange traded funds (“ETFs”) have risen in popularity among asset managers and investors in recent years for several reasons, not the least of which is the tax efficient nature of the vehicles. Despite this benefit, many active managers have been reluctant to enter the ETF space. Of primary concern to active managers is the requirement for ETFs to publish their portfolios, or “baskets,” daily. Untitled design (1)-1This transparency effectively allows others a look under the hood, which could lead to front running, which is the practice where traders buy ahead of large orders from ETFs and short sell ahead of large sell orders. This could result in ETFs paying more to purchase securities in the market and receiving less to sell securities. Another potential negative result of this transparency is the possibility of another provider effectively cloning an existing transparent ETF and offering it with a lower expense ratio.

In late 2019, the SEC approved four models for “semi-transparent” active ETFs. This development comes on the heels of the SEC’s approval of a fully non-transparent model back in May of 2019. The approved semi-transparent models, while each having some differences, are all similar in that they provide a proxy portfolio that is reflective of the ETF’s holdings. These models, along with the approved fully transparent model, would seem to provide advisors with various alternatives to address the front running and price competition concerns of launching an active transparent ETF.

Despite these developments, advisors remain reluctant to jump into the active ETF market. One reason may be the notion that the semi-transparent and non-transparent models are not as tax efficient as transparent ETFs. This is likely true, but let’s explore why. The primary mechanism for ETFs to achieve tax efficiency is the in-kind redemption process. Realized gains recognized on the disposition of securities in-kind are not taxable to the ETF. Taking it a step further, thanks to the SEC’s new ETF Rule, transparent ETFs may make use of “custom basket” or “heartbeat trades,” subject to certain conditions. Custom basket trades are creations and redemptions that do not include a full pro-rata slice of the ETF portfolio, but rather select securities for each transaction. A tax-efficient ETF can utilize custom baskets to dispose of appreciated securities in-kind, thereby avoiding the recognition of taxable realized gains, but continue to dispose of depreciated securities via market trades to harvest losses. Using these approaches, a seasoned ETF is unlikely to ever have to pay a capital gain distribution to its shareholders.

One notable aspect of the approved non-transparent and semi-transparent ETF models is that none of them allow for custom baskets. This fact certainly makes these models less efficient than the fully transparent ETFs that can take advantage of this tax-efficient strategy. However, this is not to say that a non-transparent or semi-transparent ETF will not be tax efficient. It is the in-kind redemption mechanism that is the engine of tax efficiency for an ETF, and semi-transparent and non-transparent ETFs will still operate with this engine. They will just be missing the custom basket piece that functions as the turbo charger to these engines.

In a more recent development, two of the groups with SEC approved semi-transparent ETF models have filed a request to modify their exemptive relief orders to allow them to create and redeem shares in-kind using a basket that is not the published proxy portfolio, a.k.a. custom baskets. If approved, it may be off to the races for active managers.

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