There are many benefits when it comes to investing in an ETF, such as transparency, intra-day liquidity, tax efficiency and etc. Tax efficiency is a big one and not many people may know the inner workings of an ETF to understand why an ETF is more tax-efficient than a mutual fund.
This article is set to explain how ETFs managed to be more tax-efficient than mutual funds from an operational/trading process called ‘heartbeat trades’.
When a fund sells a stock that has appreciated in value, this will trigger a capital gain tax bill for its shareholders.
However, the fund can avoid the tax bill by artificially creating a redemption and use appreciated stocks to settle the redemption. This process of using appreciated stocks to settle the artificially created redemption does not create any tax bill under the US tax codes. This is known as an in-kind redemption.
What is “Heartbeat trade”?
Composition of an index changes quite frequently. When a stock has to exit an index to accommodate a new stock entering into the index, all ETFs that are tracking the said index have to sell the exiting stock and to buy the entering stock.
As explained above, if the exiting stock has appreciated in value, selling the exiting stock will create a capital gain tax bill.
Now, how do fund issuers avoid this tax bill?
When index issuers make changes to the underlying composition of the indexes, the changes are made known in advance to the public. Armed with this information, fund issuer would then approach a friendly investment bank for a request for them to pump money/stocks into the fund that is tracking an index that is facing an impending change to its underlying index composition.
Subsequently, the same investment bank would then make a redemption from the fund. Now, instead of selling securities to raise cash to meet the redemption, the fund issuer simply hands over appreciated stocks that are going to be leaving the index to the same investment bank.
More importantly, an in-kind redemption is not a taxable event in the US.
Is this illegal?
In short, no.
The reason why fund issuers can conduct such in-kind redemption operation is that there is a loophole in the US tax codes. The tax codes state that if appreciated stocks in the fund are used to pay off investors redeeming from the fund, the fund can avoid realising the capital gain tax on the appreciated stocks.
Why ETFs benefit more from this loophole than mutual funds?
This tax code applies to both mutual funds and ETFs. However, mutual funds rarely leverage on this loophole as their investors always wanted cash.
In the ETF land, dynamics are much different. Between the ETFs and the retail investors, lies the middlemen such as brokerages, banks and market makers to facilitate the trading process. And there (the middlemen) lies the opportunity for such in-kind redemption operation to take place to take advantage of this tax loophole.
Whenever a middleman makes a redemption, the fund issuers can deliver the oldest and most appreciated stocks to the middlemen. Such in-kind redemption does not create a taxable event.
Deferment, not evasion
If the fund chooses not to conduct such ‘heartbeat trade’ operation, the fund will simply hands over the taxable gains to the end-investors and they will foot the tax bill.
Conversely, by conducting ‘heartbeat trade’ operation, the fund allows the end-investors to defer the tax bill until they sell ETF itself. In other words, it is a no-interest loan from the US Government to the ETF investors.
Case Study — Changes in index composition
Back in 2018, S&P Dow Jones Indices reclassified the GICS (Global Industry Classification Standard) classification for some of our tech darlings.
Some of the tech darlings affected by this reclassification include Facebook, Alphabet, Netflix and etc.
Summary of the reclassification
- Facebook & Alphabet will leave the “Technology” classification
- Reclassify into “Communication Services“
- Netflix will leave the “Consumer Discretionary” classification
- Reclassify into “Communication Services“
- Apple will stay put in the “Technology” classification
- Amazon will stay put in the “Consumer Discretionary” classification
The above is not an exhaustive list of all the changes in the GICS reclassification that took place in 2018.
How affected ETFs react to the reclassification
For example, the State Street Technology Select Sector SPDR Fund (XLK) was one of the many technology ETFs that were impacted as a result of the GICS reclassification.
On 19th September 2018, two days before the index changed, $3.3 billion in the form of stocks, flowed into XLK, increasing the fund size by 14%.
On 21st September 2018, the day the index changed, more than $3 billion was pulled out from the fund. Trading data suggested that the investor that pumped stocks into XLK two days earlier was the same investor that pulled from XLK on the 21st. It was also suggested that the same investor had walked away with XLK’s oldest shares of Apple and Alphabet rather than walking away with the same stock that they had pumped into XLK initially on the 19th.
At the end of the day…..
Usually, when we hear stories of such elusive/’doughy’ behaviour from the financial markets participants, it is the retail investors that suffer.
However, ETFs have democratized investing to the main street investors and more retail investors are getting exposure to the markets through the use of ETFs. Such practice, ‘heartbeat trade’ operation, is actually beneficial to the retail investors. For once, retail investors are not getting the short end of the stick from this sophisticated practice from Wall Street.
As always, take personal responsibility of your financial well-being and do your own due diligence.
Check out my recent articles:
- Direct indexing: The next chapter for ETFs?
- The creation and redemption mechanism of ETFs!
- SPIVA: Doomsday for active fund managers?
Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.