How will a shift in Washington impact the ETF space?
It's seconds out for Dave Wagner, CFA and Brad Rapking this week, CFA portfolio managers at Aptus Capital Advisors, as they get stuck into the potential impact of the US election on the ETF space…
Election years are often fraught with uncertainty. This comes with little surprise, as people are trying to figure out how shifts in political power in Washington could lead to changes in taxes, regulations and potential business opportunities. With recent tax cuts, ETF rule changes, exchange-traded note (ETN) blow-ups and the proliferation in ESG funds, we are sure to see some shifts in Washington away from what we have seen over the last four years. Let’s look at some of Biden and the Democrats’ expected policy changes if they were to win the election this year.
Biden has laid out plans to increase the tax rate on long-term capital gains and qualified dividends for those making above USD1 million. For this tax bracket, the tax rate would increase on long-term capital gains and qualified dividends from the current 20 per cent to a proposed 39.6 per cent. In this instance, the tax advantages of ETFs would become much more important when compared to mutual funds. Historically, ETFs have been much less likely to pay out capital gains distributions and when they have made payouts, they have typically been much lower. For example, a study published by Morningstar in 2019 showed that the difference between the capital gains distributions as a percentage of net asset values in mutual funds and ETFs was significant in almost every fund category they track. Based on this study, higher tax rates are only going to continue to make the tax efficiency of ETFs more compelling.
ETF rule change
In December 2019, a new ETF rule came into effect. A small part of the new rule allows nearly all ETF issuers to use custom baskets in the creation and redemption process. These custom baskets can therefore be used to lower capital gains in the funds. Without going into too much detail on in-kind transactions and custom baskets, it is important to know that this issue is likely going to continue to garner attention as the ETF issuers are avoiding a great deal in capital gains taxes. The new rule is now again on everyone’s minds after already grabbing the attention of the American Bar Association and other academics back in 2017. If we see a shift in power in Washington this fall, we could potentially see a push to overturn the custom basket function in an effort to raise taxes. As it currently stands, there are no policy changes expected, but we meet those expectations with skepticism given the major tax loophole that ETFs have taken advantage of for years.
Potential business opportunities
A Biden administration could expand business opportunities in this space. Over the last several years we have seen the proliferation of ESG factor funds. Short for “Environmental, Social and Governance,” ESG funds integrate those factors into the investment process. Managers place stringent tests on companies on how sustainable they are and how they stack up against other social and governance factors. ESG funds have come to the forefront of the market in recent years as investors look to invest in a more socially responsible manner. The Biden administration has taken a strong stance on global warming as one of its core policies is lowering greenhouse gas emissions and pushing for more clean energy. This would likely further the market opportunity for ETF providers, driving them to issue more ESG funds because of demand from retail investors and increased complexity in the ESG space and the indexes that may arise.
There are also some business opportunities that are likely to be lost in the event of a Biden presidency. A fresh example is in the ETN space. A recent article in The Wall Street Journal described ETNs as “bank-issued unsecured debt obligations, essentially IOUs, that pay a return based on the performance of an index.” It also points out that, “the bank, however, doesn’t own any of the securities or derivatives to facilitate this index tracking, so it computes the price internally. This price can be different, sometimes wildly so, from the market price, especially if demand for the ETN is so strong the bank can’t create new shares fast enough.” These ETNs also have been known to use leverage (in some cases to get up to 3x the index return), which can make losses much larger than just the normal 1x return. As of September 30, 47 ETNs have closed this year, leaving 125 still trading on major exchanges. This space and the wild swings in volatility proliferated by extreme moves in the market during COVID-19-fuelled selloffs, are likely to be reviewed due to their complexity and risk they bring to retail investors. Just look at what happened to USO during negative oil prices.
Though the Biden campaign and Democrats have not specified any policy changes that are going to immediately impact the ETF space, we feel there could be plenty of moves to be made. We think Biden’s stance on increased taxes will increase the importance of ETFs in investors’ portfolios due to their tax advantaged structures, but if we see a bright enough light shine on them, there could be legitimate changes to the processes in which they can limit capital gains. Biden’s stance on global warming is also likely to stoke the interest of both ETF issuers and investors even further into the ESG space. Whether they directly state it or not, a shift in power in Washington this fall could certainly shift the ETF space.
Dave Wagner, CFA and Brad Rapking, CFA are both portfolio managers at Aptus Capital Advisors, an ETF issuer specialising in risk-mitigated total return.