The fast-growing U.S. ETF mar- ket could be transformed by major changes in the next few
years. Here are six key areas to watch.
1. The Debut of Non-Transparent
Actively Managed ETFs
Before year-end, the first non-transparent actively managed ETFs are expected
to come to market, according to Daniel
McCabe, CEO of Precidian Investments,
which developed the strategy that allows
ETFs to conceal holdings from investors
for months at a time. The Securities
and Exchange Commission approved
the strategy in April.
A recent Cerulli Associates survey of
35 asset managers found that that 46%
indicated they would build nontransparent ETF capabilities.
Douglas Yones, head of exchange-traded
products at the NYSE, says the introduction of nontransparent active ETFs could
prove to be a “watershed moment” for
the ETF industry, leading to an explosion
of AUM above the almost $4 trillion that
traditional transparent ETFs hold today.
2. Threats to the Tax Efficiency of ETFs
The ETF tax efficiency advantage could
end because the more popular ETFs
become, the more revenue the U.S.
Treasury forfeits as a result.
Unlike mutual funds, ETFs are not
required to distribute capital gains to
shareholders when their securities are
sold for a profit to meet redemptions or
free up cash for new investments. When
redeeming — and creating — shares, ETFs
use in-kind transactions, which are not
considered cash transactions and therefore
do not result in pass-through capital gains.
Fordham University of Law Professor
Jeffrey Colon has called for the repeal
of Section 852 (b) ( 6) of the Internal
Revenue Code, which allows for the tax-free distribution of capital gains in ETFs
and in mutual funds. He labels the taxation of in-kind ETF redemptions “the
great ETF tax swindle.”
3. Heartbeat Trades at Risk?
A supersized manifestation of this ETF
tax advantage is the so-called heartbeat
trade, which ETFs use when they need
to undertake a large rebalancing. The
September 2018 restructuring of the
Global Industry Classification Standard
(GICS), which created a new communications sector, resulted in many such trades.
Technology sector ETFs such as State
Street’s Select Sector SPDR (XLK), for
example, had to sell Facebook and Google
parent Alphabet, which had large embedded capital gains, because they were moving to the new communications sector.
During such big moves, an ETF portfolio manager will arrange with a big bank
to make large purchases of shares in kind,
then quickly withdraw shares, swapping
out those with the biggest capital gains.
Because no cash is exchanged, the ETF
can avoid capital gains on the trade.
4. Vanguard’s Innovative Patent
Expires in 2023
Vanguard has figured a way for its mutual funds to use heartbeat trades to minimize capital gains. It created a patent
that essentially marries a mutual fund to
a similar ETF via an ETF share class for
the mutual fund. This allows the mutual
fund to siphon off appreciated stock
without incurring taxes.
Vanguard has conducted almost $130
billion worth of heartbeat trades since
2004, according to Bloomberg. Its patent
is due to expire in 2023, which opens the
door for more asset managers to adopt
5. SEC Rule Will Accelerate Market
Entry of New ETFs
The SEC has proposed a new rule that
allows both indexed and actively traded ETFs to come to market without
the expense and delay of applying for
individual exemptive relief so long as
the ETFs meet certain conditions such
as disclosure of certain information on
6. Some ETFs Will Move from NYSE’s
Electronic Platform to Exchange Floor
The NYSE’s is planning to list some
ETFs on the exchange floor, transferring
them from the NYSE Arca electronic
platform. ETFs currently account for
about one-third of the daily trading volume on the NYSE.
Bernice Napach can be reached at bnapach@
By Bernice Napach
6 Big Changes That Could Transform
the ETF Market
Some will increase the number of ETFs; others could restrict it.