This is a quick post that serves as a public service announcement related to a number of requests we have been receiving from registered investment advisors, mutual fund managers, and hedge fund managers regarding “launching a tax-efficient ETF.” 1
The question we keep getting, in various forms, is the following:
Can I transition assets, tax-free, from XYZ [e.g., SMA, mutual fund, hedge fund] and into an ETF?
Long story short, YES, but it’s complicated.
Situations where an ETF cannot solve your problems
First, a few things you cannot do (and yes, we have been asked these questions multiple times):
- Can I run my family office as an ETF?
- Answer: No. You cannot use an ETF as your own personal tax deferral device. You need other people to play in your swimming pool or it won’t work.
- Can I seed an ETF with my low-basis IPO stock shares [or fill in the blank monster winning stock]?
- Answer: No. You cannot dump a single stock position into an ETF and then diversify tax-free. There are strict diversification tests required to maintain an ETF’s status as a registered investment company (see below).
When can an ETF potentially solve my problems?
Here is the bottom line: You can convert an existing diversified portfolio of stocks into an ETF. But it involves a decent amount of brain damage. Of course, the potential benefits for you and/or your clients are the ability to leverage the tax-efficiency of the ETF and the ability to make your advice fees tax-deductible. 2
Again, the exact details on ETF conversions are complicated and involve the specific fact patterns around your situation, but here are some high-level requirements to convert your current investment vehicle into an ETF, tax-free. 3
Ask yourself the following questions:
- Is your intent to continue your business in the ETF structure or is your transaction strictly for tax purposes? Intent matters.
- No individual person should own more than 25% of the outstanding shares of the ETF. This will avoid making a passive ETF investor a “control person.” If the 25%+ owner is affiliated with the fund (i.e., own the ETF company) this may be less of a concern.
- ETF structures are for investing not day-trading. Transaction-heavy investment strategies don’t work well in an ETF.
- The underlying assets need to be US liquid exchange-traded stocks (or ADRs). International stocks are doable, but it adds complexity.
- No single stock position can be larger than 25% of the net asset value. Realistically, you need to be under 20%.
- The sum of 5%+ positions in your portfolio must be less than 50% of the net asset value. Ideally, this is less than 40%.
- Ideally, the portfolio contains at least 25 positions.
- For SMA situations, the underlying portfolios need to be very similar (they don’t have to be 100% overlap).
A final reminder: Starting an ETF is not easy or cheap
Finally, before leaving the comfortable world of “sticky/profitable” SMAs, “high FCF legacy” mutual funds, or “2/20 high fee” hedge fund structures, one should consider reading our piece on setting up an ETF. When you enter the ETF business you enter what Eric Balchunas deems the “terrordome.”
Please ask yourself the following questions before considering a move into the ETF business:
- Are you prepared for extreme competition?
- Are you prepared for 100% transparency?
- Are you prepared for a high fixed cost business?
- Are you comfortable with losing money for potential years on end until you reach critical mass?
- Are you masochistic and/or insane?
If you answered, “Yes,” to all the questions above, you should reach out and strike up a conversation via the contact form below:
- We surmise that projected tax policy has forced investors to explore more tax-efficient wrappers for their investment advice and/or services. Background on why ETFs are more tax-efficient is available here. ↩
- Advisory fees are generally not deductible. But management fees inside a registered fund can be netted against income, effectively making them tax-deductible. ↩
- Please note that when you convert your current asset base into an ETF you do not ELIMINATE taxes, you simply carry over your basis from your underlying investments, and your old basis is now the basis in your ETF shares. ↩