ETFs are famous for their tax-efficiency. This advantage, along with low operating costs, transparency, and the benefits of passive investing, is catapulting ETF assets to new heights, as mutual funds lose clients. Yet the trading activities around ETF portfolio rebalances are not free. In fact, this is one area where ETF transparency can bring additional costs.
Following the portfolio rebalance money—the inflows, outflows, and trading activity in the underlying securities—makes these costs knowable. The money trail is complex, but traceable. The first step is to understand the players and what role each plays. This article identifies the players. An article on trade forensics will come next, followed by a cost/benefit analysis. All are follow-ups to the revelation that ETF tax efficiency is often attributable to massive inflows and outflows around their rebalance dates, which constitutes part one of this series.
ETFs’ tax efficiency comes from the ability of ETF portfolio managers to trim positions via in-kind redemptions, rather than outright sales, thus avoiding incurring capital gains. Complex indexes such as those underlying most “smart beta” funds require periodic rebalances to keep the strategy on target. The practice of selling winners and replacing them with fresh prospects is key to these strategic indexes’ value proposition, but also introduces the risk of capital gains tax liability.
In-kind redemption allows portfolio managers to swap low-basis securities for ETF shares tendered, without realizing capital gains, as the low-basis positions are exchanged, not sold. The higher an ETF portfolio’s turnover, the greater the benefit of (and the need for) in-kind redemptions. Turnover takes place as indexes re-balance and re-constitute themselves.
The need for redemptions attracts market makers and incentivizes portfolio managers to collaborate with them to optimize tax efficiency. Market makers profit off these trades by front-running the rebalance, potentially eating away at a strategy’s potential for out-performance.
Many ETF rebalances leave two kinds of traces in the capital markets, one in the ETF itself and another in the securities the ETF holds, aka the portfolio securities. The trail starts with the ETF itself.
Heartbeat Flows - Whose Cash?
ETF rebalances are often accompanied by a “heartbeat” pattern in fund flows, with a huge inflow to the ETF a day or two ahead of the rebalance, and a matching outflow on the rebalance day. The first step in exploring these trades comes in tracking the source of the heartbeat cash.
The most plausible candidates are asset management firms and trading firms. Other types of lenders would likely shy away from the overnight exposure to changes in asset prices, as one day’s adverse movements in the stock market could easily wipe away any interest charges. Put another way, the basis risk is too high to make this loan profitable for anyone who cannot hedge it, or otherwise offset the risk.
Asset managers benefit from eliminating capital gains exposure while trading firms benefit from executing trades in the securities markets. Although asset managers have plenty of reason to lend capital to their portfolio managers in order to set up an outflow, they are legally prohibited from doing so, as this would constitute self-dealing.
That leaves the market makers. These trading firms have access to capital, holdings, and rebalance information, and the technical expertise to anticipate portfolio managers’ needs. Rebalance trades provide an excellent opportunity for trading firms to deploy capital, with the expectation of profiting from the associated trading opportunities. Because most ETF issuers have a capital markets desk that works with market makers on keeping the ETF shares trading close to net asset value, they have plenty of experience communicating about and coordinating creations and redemptions.
Off-the-record conversations with ETF market makers and asset managers has confirmed this assessment. The trades in the ETF itself, meaning the massive heartbeat inflows and outflows, come from ETF trading desks at capital markets firms. These firms partner, officially or informally, with ETF portfolio managers to facilitate smooth, tax-efficient portfolio rebalances.
Portfolio Securities Trades
ETF portfolio managers must plan their rebalance trades carefully, because of their strict index-tracking mandate. They need to know precisely which shares to buy and sell, so that they can keep the portfolio aligned with the index. Indexes can rebalance overnight, by simply swapping out one position for another. Portfolio managers on the other hand, have to trade securities, executing real purchases and sales on the trading floor.
If portfolio managers can expect outflows on rebalance day, they have the option of exchanging securities for ETF shares, in kind. The in-kind exchange is not a sale, and therefore does not trigger capital gains taxation on the profits. Redemptions on rebalance day mean that the PM has two ways to trim positions: outright sale or in-kind redemption. The first is best for harvesting capital losses, the second for washing away capital gains. Careful planning is needed regardless.
The massive heartbeat flows allow ETF portfolio managers to plan their redemptions with confidence. The inflows strongly suggest matching outflows on rebalance day, making the redemptions predictable. The size of the redemption basket is also known, as the PM can assume that the outflow share count will match the inflows.
Planning and Coordination
Clearly, this process works best if the two parties can coordinate, which can be done without outright collusion. Indeed, much of the information needed for planning is public, since the PM has to publish the exact redemption list prior to the market opening, specifying both the securities and their quantities made public via the NSCC. Moreover, daily fund flow data allows for tracking of the transaction price of each portfolio constituent. Careful accounting makes it possible to forecast the dollar value of embedded capital gains.
If the market makers know the dollar value of the capital gains exposure, they know how much capital to inject in order to optimize the redemption basket dollar value. The PM can use the basket size to plan for allocating position reductions between outright sales and in-kind redemptions.
How to Put On a Rebalance Trade
Here is how each side likely plans its part of the rebalance trade.
The Market Makers:
Total up the accrued capital gains in positions that will need to be trimmed
Create that value in ETF shares, a day or two prior to the rebalance
During the course of the rebalance day, establish a short position in the securities that will be removed from the portfolio via the redemption basket
At the end of the day, tender your ETF shares for redemption
At the end of rebalance day, you should have no position in the ETF or its underlying securities. The ETF shares created in step two are redeemed in step four, while the short positions from step three are neutralized by the long positions received in the redemption basket. If this is done correctly, market makers pocket the difference between the sale price and the day’s closing price.
The Portfolio Managers:
Note the inflows from the creations ahead of the rebalance
Identify the lowest-basis securities and mark them for the rebalance day redemption basket
Build three lists: buys, sales, redemption basket
In cases where a single name might go in both the sales and redemption basket, split them proportionally, based on available space in the basket (known from step 1) and capital gains exposure (from step 2)
On rebalance day, publish the rebalance-specific creation and redemption baskets with the NSCC
Execute the buys and sales, possibly working with a broker/dealer
At the end of the trading day, accept shares of the ETF from the market maker in exchange for the redemption basket
If portfolio managers and their partners have done this well, at the end of the day they will have a portfolio that matches the reconstituted index, and no capital gains exposure. They might have accrued a tax credit, if the sales generated capital losses. Additionally, if buys and sales are executed at the market closing price, this exercise will have perfect index tracking, as index reconstitutions and rebalances are accounted for based on the closing price.
The next article in the series will walk through an example trade in detail. The article after that will bring it all home, by adding up profit and losses for each participant. The visibility created by these forensics allows ETF investors to assess the effective cost of portfolio rebalances, a critical component of long-term investment success.