Non-transparent ETFs face up to first big tax test

Managers that stuff active strategies into the non-transparent ETF structure have found that the wrapper minimises the tax impact of portfolio moves and paper gains.

But a dearth of redemptions from such products, combined with their limited ability to use custom baskets in tax management, had caused several non-transparent ETFs to pass along year-end capital gains distributions, analysts and executives have said.

Of the 19 active non-transparent ETFs trading on January 1 2021, 10 will make a year-end capital gains distribution, according to a review of reported year-end distribution estimates. This compares with just 2 per cent of the equity ETFs offered by BlackRock, Vanguard and State Street Global Advisors, according to CFRA.

Of the 10 portfolio-shielding ETFs distributing capital gains, only two will hand off more than 5 per cent of the ETF’s net asset value: the $9m Natixis Vaughan Nelson Mid Cap ETF, which estimates an 8.9 per cent distribution, and the $7m Natixis Vaughan Nelson Select ETF, which estimates a 16.2 per cent distribution, filings show.

This article was previously published by Ignites Asia, a title owned by the FT Group.

Only one such ETF — the $98m Fidelity Blue Chip Value ETF — is expected to distribute a larger gain than its mutual fund counterpart.

Many active ETF sponsors have jumped into the non-transparent market with clones and close cousins of existing mutual funds in the hope of rekindling desire for active management in a cheaper — and more tax efficient — vehicle.

However, non-transparent ETFs have not been able to capitalise on some of the most potent ways that managers can wash away gains using the in-kind creation and redemption structure: disposing of portfolio securities with high embedded gains through redemptions and using custom baskets to make portfolio moves in a tax-mindful manner.

In addition, active strategies tend to have higher turnover than indices. As a result, many active non-transparent strategies have not been able to fully wash away the tax consequences of the strong equity market.

Some executives have said this was not a problem. “We’ve been trying to deliver the message: ‘It’s not like these won’t pay any capital gains, but it’s all about maximising after-tax returns’,” said Ed Rosenberg, head of American Century’s ETF business.

The manager wanted its five portfolio-shielding ETFs to distribute gains that were 50 per cent less than their equivalent mutual funds, he said.

American Century has only one non-transparent ETF that is more than one year old that is distributing gains, disclosures show. The ETF version of Focused Large Cap Value is expected to distribute 2.06 per cent of NAV, while the equivalent mutual fund will hand out 7.59 per cent.

Similarly, Fidelity was “pleased with what we’ve seen so far” in terms of its active equity ETFs being generally more tax efficient than mutual funds, wrote Greg Friedman, head of ETF management and strategy at Fidelity Investments.

One of the biggest challenges to active managers’ ability to wash away taxes was the fact that they were used as buy-and-hold investments and therefore did not have nearly as much creation and redemption activity as index ETFs, analysts and executives have said.

“Strong, one-directional flows in rising markets make it more difficult for any ETF to avoid distributing gains — especially those with higher turnover,” wrote Ben Johnson, director of ETF research at Morningstar, in an email. “ETFs with few — if any — redemptions will naturally have fewer opportunities to purge their portfolios of low-cost basis securities.”

And active ETFs aim for the stocks in their portfolio to appreciate — a point that managers are trying to make in tandem with their tax discussions. “First and foremost, we’re looking for alpha. We buy low and sell high,” said Scott Livingston, global head of ETF product at T Rowe Price. That primary focus gives the best outcomes to investors and then it is a matter of using the structure of the ETF to reduce costs and have relatively better tax efficiency.

But the firm was limited in how it could wash away those gains when “we don’t have that inter-period trading activity”, Livingston said. Still, the company was satisfied with the tax efficiency its funds had shown so far, he added.

Another challenge unique to non-transparent ETFs is their ability to use custom baskets to manage taxes.

“Custom baskets are of paramount importance in the semi-transparent space, if there are no redemptions,” said Terry Norman, co-founder of Blue Tractor Group, which licenses its own Shielded Alpha ETF portfolio-protecting technology to sponsors. Custom baskets allowed portfolio managers to move securities through the tax-efficient in-kind exchange mechanism, he noted.

But it was not until late this year that some ETF structures were given the green light by the Securities and Exchange Commission’s Division of Trading and Markets to transact using baskets that differ from the indices they track. And the proxy basket portfolio structures created by Blue Tractor, NYSE and T Rowe are the only ones that have such permission. Fidelity has an application for custom baskets awaiting approval and Precidian’s ActiveShares structure uses all-cash baskets to buy and sell shares.

The use of custom baskets was expected to eventually help Natixis reduce distributions in its ETFs, said Nick Elward, the company’s head of institutional product and ETFs. “While distributions were higher than we would have liked this year, they were lower than the level paid out by their sister mutual funds of the same strategy,” he wrote in an email.

*Ignites is a news service published by FT Specialist for professionals working in the asset management industry. It covers everything from new product launches to regulations and industry trends. Trials and subscriptions are available at ignites.com.

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