The Active Advantage: Tax Benefits with ETFs

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Stacie Jacobsen: [00:00:00] Thanks so much for joining us today on The Pulse by Bernstein, where we bring you insights on the economy, global markets, and all the complexities of wealth management. [00:00:15] I'm your host, Stacie Jacobsen. Today we are talking about ETFs or exchange traded funds and more specifically, actively managed ETFs.

Later we'll have guest, John McLaughlin, a national director and head of our tax and transition strategy [00:00:30] team at AB join us. Before we talk to John. Let's take the pulse of the market. Despite the recent turmoil in the banking sector, the Fed had enough confidence in the financial system stability to increase interest rates by another 25 basis points, [00:00:45] taking them to 5%.

That's a historically rapid pace of increase as we started 2022 with rates at just 25 basis points. Yes, inflation and particularly services inflation is still much higher than the fed and consumers would like it to [00:01:00] be. And the economy has continued to add a greater number of jobs each month than people entering the labor force.

But the Fed did a lot already and its actions do need time to work. And importantly, there is much more uncertainty now than there was prior to the collapse of Silicon Valley Bank. [00:01:15] We also think banks may tighten credit conditions, even if the Fed does stop raising rates. So, where does this leave us? Along with the Fed, we are keeping a close eye on the banking sector, but at this point, a scenario of a mild recession and [00:01:30] continued disinflation remains possible given the economy's strong starting point.

So, amid the uncertainty, investors looking to mitigate downside risk do have options including high quality bonds, which have once again started to play their traditional role as a [00:01:45] stabilizer in portfolios. Today we are talking about ETFs or exchange traded funds, and more specifically, actively managed ETFs.

Let's break down active versus passive trading strategies. Passive [00:02:00] investments attempt to track a well-known benchmark like the s and p 500. Investors give up the possibility of outperforming the benchmark but are often able to implement these strategies with low-cost services. Active strategies, on the other hand, rely on [00:02:15] fundamental or quantitative research and even other trading strategies to select investments.

Now, traditionally, active strategies have been delivered through mutual funds or in even some cases through separately managed accounts or SMAs. But in the past few years, active [00:02:30] ETFs have grown a lot in popularity. So, let's put that in perspective. In 2013, active ETFs had less than 50 billion in assets under management.

Now, by the end of 2022, this had grown to almost 340 billion. [00:02:45] This is still a small share of the more than 6 trillion ETF market, but it is telling that assets grew even in the difficult market conditions of last year, while total ETF assets under management fell. So why the sudden upsurge of interest? [00:03:00] Well, first regulatory reforms from the S E C did make it easier and smoother to create actively managed ETFs, but this wouldn't be a reason for growth unless there was a demand from investors for the product.

And there is clearly a demand. So, in [00:03:15] many ways, an active ETF is comparable to the established and still highly regarded mutual fund, but the former does offer greater tax efficiencies. What are those tax efficiencies? How easy are they to achieve and who can benefit [00:03:30] most? We'll be back after the break with John McLaughlin to talk more about active ETFs.

Stay with us.

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Stacie Jacobsen: Welcome back to The Pulse by Bernstein. I'm here with today's guest, John McLaughlin. He's a national director and head [00:04:15] of our tax and transition strategy team at ab. Hi John. Welcome to the show today.

John McLaughlin: Hi, happy to be here. Thanks for having me.

Stacie Jacobsen: So, let's get started. Can you just tell us what is an ETF?

John McLaughlin: Yes, great question. An ETF or an exchange traded [00:04:30] fund is a pooled investment vehicle that gives investors efficient access. To a portfolio strategy that could be in different investment types. So, think like stocks or bonds or commodities, and also across different markets. So, think about the US or [00:04:45] abroad. That's it at a high level.

Stacie Jacobsen: Many investors are very comfortable with mutual funds. So, can you do a little compare and contrast for us on ETFs versus mutual funds?

John McLaughlin: The primary difference between a mutual fund and an ETF. [00:05:00] Is really the way that cash flows occur into and out of the fund.

So, let's start first with the mutual fund, which is the simpler case for a mutual fund. Transactions actually occur once a day. At the end of the day, that's the only time they occur. And [00:05:15] so basically in any given day, you can look at how many additions are there or to the fund and how many withdrawals are there from the fund in dollar terms.

And then think about is it a net addition or withdrawal. Um, if it's a net addition, then the portfolio [00:05:30] manager is going to get some cash amount to allocate. The next day, if it's a net withdrawal, then the portfolio manager needs to raise funds by selling securities in the mutual fund strategy to create that cash.

The exchange traded fund or ET t f is a little bit [00:05:45] different, um, in that it trades more like a stock throughout the day.

Stacie Jacobsen: So why should an investor really care so much about the, you know, trading mechanisms of an ETF versus a mutual fund? What are some of the benefits for an investor?

John McLaughlin: Yeah, so [00:06:00] there's really three potential benefits that investors can, um, experience with an ETF relative to a mutual fund.

And the first, and really this is most important to me as a tax focused, um, investor at Bernstein, is that improved tax efficiency [00:06:15] now because the, the selling of securities. To create cash occurs outside of the fund through a third party called the authorized participant. That authorized participant is a non-taxable entity, and so by sending out stocks [00:06:30] or bonds or whatever it is in the strategy in kind to that authorized participant, having them sell it, that means that we don't have to create capital gains for all of the fund holders to facilitate that cash out flow.

Now that's different than a mutual fund where, [00:06:45] as I talked about before, you need to sell things to create cash that can create capital gains over time. And those gains are passed out, um, not only to the transacting investor who's taking out the money, but all to all the investors for the same strategy with the same transactions.

[00:07:00] It's going to be fewer capital gains in the normal course of management for an ETF versus a mutual fund. Now, importantly, the gains don't go away. Your cost base is tracked, right? So, whatever you bought it for and whatever you sell it for, plus or minus, any capital [00:07:15] gains or losses that occurred along the way, that still matters.

And so, you don't avoid the gains, but you defer them and deferring capital gains and taxes, you're generally a good strategy to maximize after tax return. So, I talked a lot about that first one. That's the one I'm most passionate [00:07:30] about for taxable clients. I think it's the one that's most, important. But some other benefits are because the transaction occurs outside of the fund, there's something called like market impact and transaction costs when trading.

This is more applicable to, I would say, retail mutual [00:07:45] funds than the mutual funds that our clients invest in. Our clients are longer term investors, but in periods of volatility, it may cost a little bit more to transact and with a mutual fund. Again, because the sales occur inside of the mutual fund, [00:08:00] not just the tax costs, but also the market impact costs are born by all of the fund holders.

But when it happens with an ETF, the sales occur outside of the fund through the authorized participant, and they're really applied to the transacting investor. The third is, is [00:08:15] really a cash drag because mutual funds have to be ready for cash outflows. They want to keep some cash on hand often, um, so that they don't have to sell things to create that cash.

With an ETF, you don't need to send out cash. You don't need to create [00:08:30] cash, or at least the portfolio manager doesn't. And so, they can maintain lower cash balances over time. And as you know, Stacie, you know, being invested in stocks and bonds usually gets you a better return than being in cash. And so, while that's a smaller benefit, is a [00:08:45] third benefit.

So those are what I would say are the three benefits that I see of an active ETF versus an active mutual fund.

Stacie Jacobsen: So the first one is tax efficiency. The fact that the transactions are inside of a mutual fund, where in an ETF the transactions can [00:09:00] occur outside of the ETF. The second one was costs, and we're talking transaction costs here cuz again, that's done outside of the ETF versus inside of the mutual fund.

And the third one is a cash drag in an ETF. The cash can be invested where in mutual funds, the [00:09:15] manager may hold a little bit on the side for any of those end of day transactions. Did I get it?

John McLaughlin: Well said.

Stacie Jacobsen: Are those amounts actually very noticeable to an investor and how much might that benefit be in an ETF versus a mutual fund?

John McLaughlin: It can definitely make a difference. Um, in terms of [00:09:30] capital gain, tax drive obviously only applies to taxable investors, but it can be meaningful if you think about like a passive ETF, so that's like shares S&P 500 fund. That's a strategy where an investor gets exposure to the S&P 500.

Typically they don't pay capital gains unless they sell their underlying units. Even when the components of the S&P 500 change, now an active ETF is, gets you close to that kind of tax efficient [00:10:00] exposure. So you're, you know, you're not necessarily bringing the capital gain amount to zero, but you're certainly reducing it pretty significantly.

Stacie Jacobsen: John, in my intro I mentioned that the SEC made it easier and smoother to create actively managed [00:10:15] ETFs. Can you tell us what occurred?

John McLaughlin: Yes. So basically the change really made active ETFs more efficient. Like that's what's most exciting about this rule change in from 2019. The way that it worked before for active ETFs [00:10:30] was that when you're making an addition to the ETF or taking funds out of the ETF, Those are actually gonna occur with securities, and those securities basically had to look like the overall portfolio.

Now, passive ETFs have worked a little bit differently. Um, so [00:10:45] passive ETFs, meaning like index funds, have been able to take advantage of an opportunity to send things out that the portfolio manager wanted to sell. Why that's important is that, let's say Apple falls out of the S&P 500. In a [00:11:00] passive ETF, that transaction would've occurred by sending that apple out with cash flows, not having to sell it in the fund and not having to pass that capital gain through to the fund holders.

Now, the 2019 rule said that active ETFs could do that [00:11:15] too, which is huge because Active ETFs has a lot more turnover in trading as the portfolio manager is trying to actively position. But now that same active ETF can have tax efficiency that's much, much improved over the way it was [00:11:30] before.

Stacie Jacobsen: I've heard about mutual funds converting to ETFs.

Is that something that the mutual fund manager decides is the right decision and how might that benefit an investor?

John McLaughlin: Yes, you've seen it a lot in the news. I, I would say, you know, there's a lot more [00:11:45] news than dollars transacted. At the end of the last year, there was about 60 billion of mutual fund assets that were converted to ETFs.

You know, compare that to the 11.3 trillion dollars in active mutual funds at the end of last year. [00:12:00] Yeah. A small amount, not a lot of, not a lot of companies have done it. It's complicated when considering the transaction. Basically, you know, it could be the portfolio manager or someone that invests the underlying client money like us, or it could be the board that says, [00:12:15] you know, we should consider this.

There's then the cost benefit analysis, you know, it's not free to, can make a conversion that needs to be considered. Now importantly, some strategies, and I've talked a little bit about a lot about the benefits of an ETF versus a mutual fund. Sometimes [00:12:30] when a mutual fund's actually gonna be a better option for exposure than an ETF, one of the attributes of an ETF is that this kind of unlimited flow of capital in or out.

And so a portfolio manager of an ETF has to be ready for [00:12:45] potentially unlimited cash inflows. That sounds like a good thing from a portfolio manager perspective, but there's some strategies that have limited capacity where the investor or the portfolio manager, you know, can expect to generate the premium that they've set out to [00:13:00] get the end client.

So think like smaller cap stocks, where if you know there's a trillion dollars of inflows, like you're not gonna be able to run an effective you know, small cap strategy, uh, because you're just gonna be way too big of a position in names or they're not gonna [00:13:15] be enough names for you to purchase.

Stacie Jacobsen: Okay. So that leads me to my next question.

So, if an investor is faced with a decision to gain exposure to a specific asset class through either an ETF or a mutual fund, how should they think about that decision? [00:13:30]

John McLaughlin: Yeah, they should work with us, right? We can help with that decision. Um, a lot's gonna matter in terms of the investor's horizon, their tax situation.

Are they investing, you know, through a taxable account or a retirement account? You know, oftentimes there are more choices than just an ETF or a mutual [00:13:45] fund. You know, we offer strategies through separately managed accounts, which may make sense as well. We're gonna try to give as clients as many, like good options as they're available to help them come up with the optimal exposure.

It's really about asking questions, understanding their situation, and [00:14:00] we can help make an informed decision. In general, I don't think that we will offer many strategies in mutual fund and ETF form. I think we'll offer, you know, the same strategy sometimes in separately managed account, or SMA, and then also in, you know, mutual [00:14:15] fund or, or ETF on the side.

So that will kind of be the decision. First question is like, is the investment strategy the right strategy for you? And again, your financial advisor should help you with that decision.

Stacie Jacobsen: Now, you've brought up the SMA a couple of times. Can you just do [00:14:30] a, a quick explanation as to what that is?

John McLaughlin: Yes. Thanks for asking.

An SMA, um, that's, we try not to use acronyms because we're very ingrained in it, but it stands for a separately managed account, right? So that means that instead of investing through a mutual fund or an ETF. [00:14:45] The portfolio manager is allocating an investor into individual stocks or bonds. Um, that are in their individual account.

So that's what a separately managed account is.

Stacie Jacobsen: John, your focus on the day-to-day at Bernstein is tax efficiencies for our clients. We've [00:15:00] talked about the benefits of both ETFs and mutual funds. So when an investor is looking to implement a strategy, what should they really be focused on?

John McLaughlin: They should be focused on finding a financial advisor who is tailoring a solution to them.

That is gonna be the most [00:15:15] important thing. So that starts first and foremost with making sure that the investment strategies are appropriate. Um, but also importantly, are we taking advantage of all the implementation options that exist today? At Bernstein we are laser focused on both of those [00:15:30] things. We wanna be taking advantage of all the tools in the toolkit.

I'm super excited that we have another important option for clients. And we're gonna make sure that all clients are aware of the different choices that can help [00:15:45] maximize their chance of success.

Stacie Jacobsen: Great. John, thanks so much for educating our audience on ETFs and the possibilities that they bring for their portfolio.

Appreciate you being with us today.

John McLaughlin: Thank you for having me.

Stacie Jacobsen: Thanks to everyone for tuning in. You'll hear from [00:16:00] us again on April 25th where we'll talk all about cash. You won't wanna miss it. Don't forget to subscribe to the Pulse by Bernstein wherever you get your podcast. To ensure you never miss a beat.

I'm your host, Stacie Jacobsen, wishing you a great rest of the week.[00:16:15]