The Inner Workings of ETFs

The Inner Workings of ETFs

By Gil Baumgarten, Segment Wealth Management, LLC

I wrote last week about the importance of considering taxes in investment strategy. Brokers tend to sweep tax considerations under the rug because they make more money from active strategies which create taxes as a byproduct. Beware if you hear the cliché that taxes prove you are making money. Yes, but optional. Different investment products have far different taxation, which, if ignored, can weigh heavily on returns. 

Open-end funds (typically the ones with 5-digit symbols) have structural issues that make alternatives like ETFs a better choice on multiple levels, taxes being #1. Open-end funds use commingled accounting. While you may have your own share balance on your own statement, each shareholder’s unrealized gains from each stock in the fund are mixed in a common pile. This might be no big deal on a typical day, whereby the fund experiences $50 million in inflows and $50 million in outflows. The fund simply swaps buyer cash and seller fund shares, and no taxable activity occurs. The problem arises when you have $100 million in fund redemptions and only $40 million in daily purchases. That $60 million shortage requires the sale of underlying stock positions. The gains on that $60 million are distributed periodically and often end up as reinvested shares, but that taxable activity is reported at year-end as capital gain distribution. This process drains compounding and has several other deleterious effects. That taxable gain appears on your year-end 1099, along with the effect of all the other days of mismatched activity and regular portfolio realignment trading inside active funds. 

Contrast the open-end fund accounting with the structure of ETFs. The creation and redemption action in ETFs is invisible and automated behind the scenes. Essentially, ETFs require new shareholders to provide the representative underlying securities. Those shares are admitted to the fund in exchange for fund shares in what is called the “creation unit process.” Similarly, sellers of ETF shares exit the fund with underlying shares in hand, and they take their activity’s taxability with them. This process makes distributable (and taxable) activity near zero for most ETFs, even with large and disparate sizes of daily buys and sells. No reconciliation must take place inside the fund, so it’s not reportable.

That deferral of capital gains taxation has several profound comparative advantages over time:

  • It can add a fourth to compounded return over 30 years.
  • It gives ETF shareholders a more powerful currency for philanthropy.
  • It gives ETF shareholders more powerful gifts to less-taxable family members.
  • It vastly increases the benefit of a tax-free step up at the owner’s death. Check with your family tax counsel to see how this applies to you.

Unlike brokers, fiduciaries cannot make side deals with fund providers, nor can they earn 12b-1 fees. You are more apt to hear about ETFs’ inner workings from fiduciary advisors who have a vested interest and legal requirement to understand and discuss them with clients. If this is news to you, maybe you’ve been talking to the wrong folks.

For more information, please contact Haley Parmer at (713) 800-7158 or [email protected].

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