New 'investor-friendly' ETFs unlock tax deferral on appreciated assets

Clients with diversified yet heavily appreciated stocks could more effectively defer capital gains and avoid the tax hit of dividends by converting them into a newly burgeoning type of ETF.

Transferring the varied holdings into an ETF with a similar basket of investments based on the rules of Section 351 of the Internal Revenue Code enables what is known as an "in-kind" exchange of assets. The approach has existed for nearly a century, but a raft of new ETFs — starting with the launch last month of the Cambria Tax Aware ETF (ticker: TAX) — reflect how financial technology is applying it on a mass scale, according to Mebane "Meb" Faber, co-founder and chief investment officer of Cambria Investment Management. The quantitative management and alternative investments firm collaborated with ETF tax and operational advisory firm ETF Architect on the Dec. 18 start of TAX.

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Appreciated stock portfolios — especially those using increasingly popular forms of direct indexing — can often get "stuck" in limbo with their rising values and the potential for realizing taxable capital gains, Faber said. Financial advisors could think of the Section 351 transfer as a 1031 like-kind exchange that is for stocks rather than other kinds of assets. Even though the tax law provision has existed for a long time, some "99.9% of people" that Cambria spoke with in several hundreds of calls last quarter hadn't heard of Section 351 transfers, according to Faber. The Securities and Exchange Commission's 2020 ETF Rule cleared the way for software and other technology powering new products that focus on the tax impact of asset location.

"These are all ideas and strategies that are going to get developed more over the next five years," Faber said. "You're going to see an enormous amount of interest in this in the next six months as people kind of get it and shift."

'Kind of a big deal': How Section 351 ETFs work

The TAX ETF and other funds coming to market soon represent "a very investor-friendly trend" toward returns with less risk at a lower cost, according Brent Sullivan, a consultant on taxable investing product marketing and development to sub-advisory and ETF firms. Sullivan writes the Tax Alpha Insider blog, where he's tracking a half dozen new or pending funds from Cambria and three other sponsors pitching the Section 351 transfer strategy. Sullivan has been following the launch of TAX closely for several months, and he wrote in a "28 Days Later" dispatch earlier this month with samples from his upcoming "memezine" explaining Section 351 conversions to advisors. ("I hate white papers," Sullivan wrote. "They feel like homework. So, I wrote and illustrated an adviser's guide to seeding ETFs in-kind using some words, but mostly memes.")

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Section 351 exchanges revolve around the idea of moving "disaggregated assets into an aggregated fund that can achieve lower cost and also better tax deferral" without booking any capital gains, he said. They could be beneficial to, for example, clients in "separately managed accounts that are way above cost basis so they can't do tax loss-harvesting anymore," according to Sullivan. In effect, stock assets in a status informally known as "locked" due to their potential tax burdens flow into a diversified ETF.     

"It removes tax friction from the reallocation decision. It makes assets less sticky, and, in general, that's good," Sullivan said. "It's kind of a big deal, and advisors are the ones who are going to be needing to vet these products, because oftentimes they don't come with a track record."

Just over a month after its inception, the TAX ETF has attracted $32.5 million of net assets. It carries an expense ratio of 0.49% and the requirements that no single positions in an incoming portfolio comprise more than 25% of the holdings and any that are over 5% add up to less than 50%. Cambria intends to open two more funds that use Section 351 conversions this year, with an ETF using the ticker "ENDW" that "tracks an endowment-style allocation" across global holdings at the end of the first quarter and another targeting global equities at the end of the second, according to Faber. Advisors have likely grown familiar with the fact that mutual funds are converting to ETFs, he noted. Section 351 transfers could drive more assets to ETFs.  

"We knew there was going to be some demand for this idea and topic, and it was 10 times what we expected," Faber said. "If you're a taxable investor, particularly a high-tax investor, the last thing you want is dividends, because you're paying taxes on those every year."

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The new ETFs are giving more advisors and their clients the opportunity to use a tactic that was previously only available to the wealthiest households, according to Sullivan.

"Meb is doing this all out in the open," Sullivan said. "Normally this is only offered to family offices and in really one-on-one, behind-the-scenes sales. The public appeal is specifically what's new about this moment."