It’s a double whammy year for US investors who are approaching their tax year end, facing portfolio falls and potential tax bills on their mutual fund portfolios, says Derek Hernquist, Head of Advisor Experience at USD3.9 billion Aptus Capital Advisors.
The US has its much-celebrated in-kind tax treatment of ETFs but for those investors who are in mutual funds, tax implications lie in the mutual fund’s turnover. Hernquist says: “If a mutual fund manager decides to sell a holding, it automatically triggers for the individual investors in the mutual fund, regardless of how long they have held it.”
This means that if the fund has owned Apple for 10 years and achieved hundreds of percentage points of performance for its investors, and the fund manager sells Apple, a new shareholder who joins on November 30th will face their own share of the pro rata tax fees, despite not participating in the growth.
“The biggest problem is it takes some of the tax control out of shareholders or advisers’ control,” Hernquist says. “It’s like joining a group at a bar and buying a drink, where people have been spending money for three hours: you have one drink and you owe X per cent of the three hour tab.”
ETFs in the US do not need to distribute capital gains, most of the time.
“The taxes are based on ‘I bought at this price, sold at that price, and I pay taxes on my gain,” he says. Mutual fund companies are also experiencing general outflows toward ETFs, forcing managers to sell shares to come up with the cash.
“I think this will continue to drive investors towards ETFs,” Hernquist says. “A capital gain when your fund is up 20 per cent you can overlook but when it’s down 20 per cent, that is a tough pill to swallow.”
Hernquist believes that those tailwinds are going to continue partly due to tax reasons but also because ETFs can now participate as active managers. “They used to be known as a passive vehicle, enabling you to get pure beta exposure. But the SEC ETF rule in 2019 allowed active ETFs to get the same tax benefits as passive ones, and it has created new ETF strategies that advisers can use – it’s small but growing quickly.”
Aptus Capital Advisors, founded in 2013 and with its first product in 2016, runs options based active ETFs, designed for total return. The firm has six funds, five of which have an options component designed to protect against market downside and provide alternatives to common return drivers.
“It’s a challenging market for advisers but there is definitely a need for something other than traditional stock and bonds,” Hernquist says.