Proposed tax law changes may accelerate a transition from mutual funds to active ETFs
Ross Klein (pictured), Founder and Chief Investment Officer at Changebridge Capital, writes on the potential effects of a proposed tax law change in the US on ETFs.
A recent proposal by the Biden administration would remove the preferential tax considerations for long term holders of stocks. Currently, Americans’ top tax rate for long-term capital gains (positions held more than one year) is 23.8 per cent, including a Medicare surtax. Recent proposals would bring the top rate to 43.4 per cent, and no longer differentiate between long-term and short-term capital gains. This is a material change that likely impacts the way investors approach their personal trading.
Tax considerations will increasingly incentivise investors to allocate capital towards non-taxable and tax-deferred accounts, such as IRAs, and 401(k) or 403(b) plans. Taxable accounts would be exposed to these higher tax rates, where the benefits associated with the ETF structure become more pronounced.
For investors who currently allocate to actively managed Mutual Funds, a new option is quickly gaining traction: Active ETFs. While Active ETFs have been available since 2008, they’ve only begun to gain traction within the past five years. Active ETF assets have grown from USD50 billion in 2015 to USD100 billion in 2018, and over USD200 billion in 2021. The number of Active ETF’s has doubled since 2018, per a recent Morningstar report.
Why are active ETFs potentially more tax efficient than active mutual funds?
Let’s compare the movement of cash between investors and the underlying funds in both an Active ETF and Mutual Fund structure. In a Mutual Fund, new capital is sent directly to the fund, which the manager uses to purchase securities which are to be fund holdings. Each of these transactions come at a cost to all of the pooled investors in the fund, regardless of which particular investor(s) allocated new capital. Perhaps more relevant from a tax perspective, when an investor in a Mutual Fund seeks to withdraw capital, the manager must sell securities to meet that redemption request. If those securities were held at a gain by the mutual fund, this may result in a taxable event for all investors in the Mutual Fund.
An Active ETF differs, in that buying and selling of the underlying fund may occur in the secondary market, on an exchange such as NYSE Arca, Nasdaq, and CBOE. The Changebridge Capital Long/Short Equity ETF (Ticker: CBLS) and the Changebridge Capital Sustainable Equity ETF (Ticker: CBSE) (together the “Funds”) are listed on the NYSE. When buying on the secondary market is larger than the amount of selling, a third party known as an “Authorised Participant” (AP) has the ability to create new shares of the ETF to meet investor demand, and can deliver the underlying holdings of the portfolio into the ETF. For instance, when buying demand for CBSE (Changebridge Capital Sustainable Equity ETF) leads to new shares being created, an AP will deliver the holdings of CBSE on behalf of the fund, thus avoiding the transactional expenses and potential capital gains experiences seen in the Mutual Fund example. Inversely, when selling in the fund exceeds demand (resulting in redemptions) the selling shareholder(s) are able to receive cash while an AP is able to deliver securities from the fund, reducing taxable events at the fund level. In this scenario, the manager may not need to sell portfolio holdings to meet the change in demand.
Mitigating capital gains transactions has always been an important feature for Active ETFs and the ETF structure in general, but with the potential for capital gains rates to increase in the future, investors will want to gain a better understanding of the tax dynamics for ETFs relative to other investment alternatives.