ETF Education

An ETF, or Exchange-Traded Fund, is a type of investment fund that trades on stock exchanges, similar to individual stocks. ETFs are popular among investors because they can offer several advantages over traditional mutual funds, such as liquidity, lower expense ratios, and the ability to trade throughout the trading day at market prices.

Key characteristics of ETFs:

• Diversification
  ETFs typically hold a basket of assets (e.g., stocks, bonds, commodities), providing investors with instant diversification within a single investment.

• Transparency
  ETFs publish their holdings daily, allowing investors to know exactly what assets the fund contains.

• Market Price
  Throughout the trading day, ETF shares are bought and sold on stock exchanges at market prices, which can fluctuate based on supply and demand.

• Lower Costs
  ETFs often have lower expense ratios compared to traditional mutual funds, making them an attractive option for cost-conscious investors.

• Flexibility
  Investors can buy and sell ETF shares at any time during market hours, unlike mutual funds that are priced and traded only once a day after the market closes.

• Tax Efficiency
  ETFs are generally more tax-efficient compared to mutual funds due to the way they are structured and how they handle capital gains.

ETFs generally offer certain tax benefits compared to mutual funds due to their unique structure and the way they are traded. Some of the key tax advantages of ETFs include:

• Tax Efficiency
  ETFs are structured in a way that can make them more tax-efficient than mutual funds. When an investor buys or sells shares of an ETF on the stock exchange, they do so with other market participants, not directly with the fund company. As a result, there are fewer taxable events within the fund itself, which can help minimize capital gains distributions.
  
  On the other hand, mutual funds are required to sell underlying securities to meet redemptions or rebalance their portfolios. These sales can trigger capital gains, which are then passed on to the fund’s shareholders, even if they did not sell their mutual fund shares. This can lead to unexpected tax liabilities for mutual fund investors.

• In-Kind Creation/Redemption
  ETF shares are created and redeemed “in-kind,” meaning that when new shares are issued or existing shares are redeemed, it is typically done using a basket of underlying securities, not cash. This creation and redemption process helps prevent the realization of capital gains within the ETF itself, contributing to its tax efficiency.
• Control Over Timing
  ETF investors have more control over the timing of their capital gains. Since ETF shares are bought and sold on stock exchanges, investors can choose when to enter or exit their positions. This control can be beneficial for tax planning purposes, as investors can time their trades to minimize taxable events in a way that suits their personal financial situation.
  
  It is important to note that it is possible for ETFs to distribute capital gains, which is an action that is outside investor control, though the frequency of such distributions is far less frequent than with mutual funds.

ETFs can often trade without triggering capital gains due to their unique “in-kind creation and redemption” process and the specific tax treatment they receive under U.S. tax laws. This process usually allows ETFs to be more tax-efficient compared to traditional mutual funds.

Here’s how it works:

In-Kind Creation and Redemption
ETF shares are created and redeemed “in-kind” by authorized participants (APs). These are typically large financial institutions that have a special arrangement with the ETF issuer. When new shares of an ETF are created, the AP delivers a pro-rata basket of the underlying securities that make up the ETF’s portfolio to the ETF issuer. In return, the AP receives newly created shares of the ETF. Conversely, when an investor wants to redeem ETF shares, they can do so with the ETF issuer in exchange for the underlying basket of securities. This in-kind creation and redemption process helps avoid triggering taxable events within the ETF.

Tax Treatment of Redemptions
When an AP redeems ETF shares, they typically redeem the most appreciated or “low-basis” securities from the ETF’s portfolio. This means that the ETF can effectively pass on its low-cost basis securities to the AP, which helps minimize capital gains. Conversely, in mutual funds, redemptions are generally treated on a “first in, first out” (FIFO) basis, potentially leading to higher capital gains taxes.

It’s important to note that while ETFs are generally more tax-efficient, they are not entirely immune to capital gains taxes. If an investor sells their ETF shares for a profit, they will realize a capital gain, just like with any other investment. However, the in-kind creation and redemption process, coupled with the other tax-efficient mechanisms, help reduce the likelihood of generating significant capital gains within the ETF’s structure itself, thereby benefiting long-term investors with lower tax liabilities.

Please note that this is one isolated example, which has been selected due to the use of Avantis products within CCM client portfolios. This is for illustrative purposes and results will vary as we compare the tax impact of other products. Tax benefits will vary based on a number of factors such as timing, cash flows, rebalancing trades, etc.

Avantis Investors offers a US small value strategy in both mutual fund (AVUVX) and ETF (AVUV) structure. Although these investments are not identical due to differences in how mutual funds and ETFs are traded, they are incorporating the same strategy and managed by the same portfolio manager. The primary distinction is their investment vehicle structure.

Morningstar provides us with a tool to evaluate the tax efficiency of mutual funds and ETFs, called their “Tax Cost Ratio”. According to Morningstar:

“This ratio measures how much a funds annualized return is reduced by the taxes investors pay on distributions. Mutual funds regularly distribute stock dividends, bond dividends and capital gains to their shareholders. Investors then must pay taxes on those distributions during the year they were received.

Like an expense ratio, the tax cost ratio is a measure of how one factor can negatively impact performance.

For example, if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis.”

For the three years ending June 2023, the tax cost ratio for Avantis’ mutual fund, AVUVX, was 1.45%. The tax cost ratio for Avantis’ ETF, AVUV, was 0.65%. We can see how the ETF structure has lowered the tax cost ratio for taxable investors, improving after-tax return by 0.80%.

ETFs are increasingly the preferred investment structure over mutual funds, as investors appear to favor the tax, liquidity, and transparency improvements they offer. New fund launches have steadily moved in favor of the ETF structure, and investor fund flows have increasingly favored ETFs and indexed mutual funds over active mutual funds. (Source: https://www.ici.org/doc-server/pdf%3A2019_factbook.pdf)

The ETF Rule refers to a regulation adopted by the U.S. Securities and Exchange Commission (SEC) that facilitates the process of launching and operating exchange-traded funds (ETFs). The rule was officially named Rule 6c-11 and it was adopted by the SEC in September 2019.

The ETF Rule aims to streamline the regulatory requirements for ETFs and provide a more efficient pathway for new ETFs to come to market. Before the ETF Rule, most ETFs had to apply for individual exemptive relief from certain provisions of the Investment Company Act of 1940, which could be a time-consuming and costly process.

Key provisions of the ETF Rule include:

• Custom Basket Flexibility
  The rule allows ETFs to use “custom baskets” when engaging in in-kind creations and redemptions with authorized participants. Custom baskets provide ETF managers with more flexibility in creating and redeeming ETF shares, allowing for greater tax efficiency and improved management of the ETF’s portfolio.

• Transparency
  ETFs must disclose certain information about their portfolio holdings on a daily basis. The ETF Rule requires that ETFs disclose information about their intraday indicative value (IIV), which provides investors with a real-time estimate of the ETF’s net asset value (NAV) throughout the trading day.

• Intraday Pricing
  The rule requires that ETFs publish their NAV per share at regular intervals throughout the trading day, typically every 15 seconds. This helps investors to better understand the ETF’s pricing and its relationship to its underlying portfolio.

• Disclosure Requirements
  ETFs must provide certain disclosures to investors, such as information about premiums or discounts to NAV and bid-ask spreads, to help investors make informed decisions about trading ETF shares on the secondary market.

The ETF Rule was designed to make the process of launching and operating ETFs more efficient, encourage innovation in the ETF industry, and provide additional protections and information to investors.  It is part of the SEC’s ongoing efforts to adapt regulations to the changing landscape of investment products and enhance investor confidence in the financial markets.

An ETF Fund of Funds is an ETF which utilizes other ETFs as the underlying holdings, and may also own individual stocks or bonds. 

For example, Blackrock offers a suite of ETFs which utilize iShares ETFs as the underlying holdings for their risk-tolerance portfolios.  The methodology of which ETFs are owned, and in which proportion, are determined by the risk tolerance of each ETF.

Avantis Investors also offers their Avantis All Equity Markets ETF, which is also an ETF fund of funds.  This ETF has 10 Avantis ETFs as the underlying holdings, which are regularly rebalanced to target weights.

The create and redeem process allows for in-kind transactions that allow the ETF fund of funds to rebalance and replace underlying holdings without being required to distribute the capital gains associated with those trades.

Every ETF has underlying expenses related to operating and managing the fund.  An ETF Fund of Funds has two layers of expenses, one for the ETF itself, and a second layer for the underlying ETFs used within the fund.  To determine the all-in cost of the fund, we can look to the prospectus net expense ratio, which illustrates the total cost to the shareholder.

Tax deferral and step-up in basis are two important concepts in the realm of taxation, particularly in relation to investments and estate planning.

Tax Deferral

Tax deferral refers to the postponement of paying taxes on certain types of income or gains until a later date, typically when the funds are withdrawn or distributed. The idea behind tax deferral is that by delaying the tax obligation, the taxpayer can potentially benefit from increased investment growth over time.

One common example of tax deferral is within retirement accounts like 401(k)s and Individual Retirement Accounts (IRAs). When individuals contribute to these accounts, they usually receive a tax deduction for the amount contributed, reducing their taxable income for the current year. The funds within the account can then grow tax-free until they are withdrawn during retirement, at which point they are subject to taxation at the individual’s ordinary income tax rate.

Another example of tax deferral is seen in certain investment vehicles, such as deferred annuities. With deferred annuities, any interest or investment earnings are not immediately taxed, allowing the funds to compound and grow tax-free until they are withdrawn.

Step-up in Basis

Step-up in basis is a provision in the tax code that allows the value of an asset to be “stepped up” to its current market value at the time of the owner’s death. This step-up in basis occurs when an individual passes away and leaves assets to their heirs, such as real estate, stocks, or other investments.

The step-up in basis is particularly relevant in capital gains tax calculations. Normally, when someone sells an appreciated asset, they have to pay capital gains tax on the difference between the asset’s original cost (or basis) and its current value. However, when an asset is inherited, the basis is adjusted to its value on the date of the original owner’s death. This means that if the heirs sell the inherited asset shortly after acquiring it, they will likely incur little to no capital gains tax because there would be little to no difference between the stepped-up basis and the sale price.

The step-up in basis can be a significant benefit for beneficiaries, as it allows them to avoid paying taxes on the unrealized gains that occurred during the original owner’s lifetime.

Both tax deferral and step-up in basis can play essential roles in minimizing tax liabilities and maximizing the after-tax value of assets for individuals and their beneficiaries. However, it’s crucial to consult with tax professionals or financial advisors to fully understand how these concepts apply to individual situations, as tax laws can be complex and subject to change.

A 351 exchange refers to a section of the Internal Revenue Code that refers to corporate reorganizations (section 851). 

This code section allows for a tax-free exchange, provided diversification rules are met, of securities into a newly created entity, such as an ETF.  Doing so allows for continued tax deferral, while implementing a more tax-efficient ETF structure.

Importantly, this exchange is a one-time event, only conducted at the launch of the new ETF.

Individual stocks and equity ETFs are eligible for inclusion in the 351 exchange, whereas mutual funds are not.  Securities must meet diversification rules in order to be eligible for inclusion.

Although there are numerous complexities that go into a transaction, the two most relevant diversification rules are the following:

1. No holding can account for more than 25% of the account value that is being transitioned.
2. The five largest holdings must hold less than 50% of total account value being transitioned.

Fortunately, ETFs receive a “look through” benefit.  This means that the diversification rules apply to the underlying holdings of the ETF, not the ETF itself.  So if a portfolio had 30% invested in Vanguard’s Total Stock Market ETF (VTI), that would exceed the 25% threshold listed above, except that as an ETF the analysis would be performed on the thousands of underlying holdings, which easily meet the diversification limits.

Since the adoption of the ETF Rule in 2019 by the SEC, there have been numerous examples of investment managers converting mutual funds or separately managed accounts into ETFs.  As an example, prior to this rule change, Dimensional Fund Advisors had not offered ETFs as an investment structure.  However, since this rule change, DFA has launched several ETFs and transitioned many of their tax managed mutual funds into ETFs.

The 351 exchange evaluates each transitioned position on a tax lot by tax lot basis.  This means that the converted assets retain their existing value and cost basis.

EXAMPLE

Account holds the following three ETFs:

ETF #1

• Tax Lot #1 – Value = $10,000, Cost Basis = $5,000
• Tax Lot #2 – Value = $25,000, Cost Basis = $15,000

ETF #2

• Tax Lot #1 – Value = $50,000, Cost Basis = $35,000

ETF #3

• Tax Lot #1 – Value = $15,000, Cost Basis = $10,000
• Tax Lot #2 – Value = $5,000, Cost Basis = $1,000
• Tax Lot #3 – Value = $20,000, Cost Basis = $15,000

The total value of this account is $125,000, and total cost basis is $81,000.

After the 351 conversion, the account will hold just the one new ETF, but will now have six tax lots.

New ETF

• Tax Lot #1 – Value = $10,000, Cost Basis = $5,000
• Tax Lot #2 – Value = $25,000, Cost Basis = $15,000
• Tax Lot #3 – Value = $50,000, Cost Basis = $35,000
• Tax Lot #4 – Value = $15,000, Cost Basis = $10,000
• Tax Lot #5 – Value = $5,000, Cost Basis = $1,000
• Tax Lot #6 – Value = $20,000, Cost Basis = $15,000

The new ETF now has the same $125,000 value, and $81,000 in cost basis.  The new ETF also retains each of the same values in each tax lot.  These lots can be utilized to optimize both charitable giving and cash flow needs.

Due to the application of the 351 exchange on a tax lot by tax lot basis, the ability to identify the most appreciated positions to optimize charitable gifting is not affected. After a 351 exchange, the investor still has full flexibility to identify and fund charitable contributions using low basis positions that are highly appreciated.