Active ETFs and tax efficiency

[chang]

Simple question - do active ETFs have the same (or similar) tax efficiency advantages that passive ETFs have?

If active ETFs have a higher turnover than passive ETFs, then it's hard to see how they can avoid the same CGs and tax inefficiencies that OEFs have. 

[chang]

I'm thinking of TCAF in particular. The Fact Sheet actually says:

"Aim to provide similar or better tax efficiency than an S&P 500 ETF." How is this possible?

[yogibearbull]

That looks like a strange claim in TCAF Fact Sheet (BTW, I own TCAF in several accounts now). May be they (the ad people at T Rowe Price, who often write strange copies) meant all funds benchmarked to SP500.

I have a running argument with M* authors where I maintain that in-kind trading without tax consequences is the main reason for ETF tax efficiency. But M* authors say that indexing is the primary factor for tax efficiency, and then, the in-kind trading w/o tax consequences has an additional secondary effect.

May be so, if one limits to the universe of market-cap indexing, the cheapest kind of indexing.

But if one includes active ETFs, factor ETFs, equal-weight ETFs, and even market-cap indexed ETFs, I still maintain that in that universe, in-kind trading w/o tax consequences is the primary factor for ETF tax efficiency.

In 2023, several index funds had notable CG distributions. Reasons were heavy outflows. After all tricks related to in-king trading w/o tax consequences and indexing are exhausted, an existing fund may just have to sell old low-cost positions that will generate CGs, but these seem exceptions rather than the rule.

www.mutualfundobserver.com/discuss/discussion/61601/high-yearend-distributions

[bizman]

Jan 22, 2024 20:45:47 GMT chang said:

I'm thinking of TCAF in particular. The Fact Sheet actually says:

"Aim to provide similar or better tax efficiency than an S&P 500 ETF." How is this possible?

In a podcast interview, David Giroux said he planned on keeping the turnover very low, like 5 - 15%.  IIRC, this emphasis on keeping turnover low, and potentially "favoring" PRWCX (so as to perhaps not telegraph all of its portfolio moves in real time) was a reason that anitya was less enthusiastic about TCAF or at least further adding to it?!?

Also IIRC, Giroux thought he could beat the S&P 500 by 1%+ per year in TCAF (PRWCX's stock sleeve has apparently beat the S&P by 4% per year I believe I saw somewhere), with better tax efficiency going forward.

By the way, I've got a good sized slug of TCAF.  I'm also keeping an eye on CGUS.  


EDITED TO ADD:

The Long View Podcast: David Giroux: ‘I Want to Look Forward, Not Backward’

From transcript:

Benz: So, sticking with TCAF, the ETF, there’s some overlap between the new ETF’s holdings and the equity sleeve of the flagship T. Rowe Price Capital Appreciation Fund, which has been closed since 2014. So, given that you can’t shut an ETF to new inflows, how do you think about ensuring that you’re running manageable sums without exceeding the stock strategy’s capacity?

Giroux: It’s a great question. It’s something that we’re very, very focused on early in the process to see if this was going to work. So, prior to launching the TCAF strategy, Chen Tian, who’s basically the head of Quant on CAF and we did a series of analysis, looked at capacity at different sizes. And we basically came to the inclusion because this is, again, more of a large-cap-focused strategy that we could get to $50 billion to $100 billion in TCAF over time and really have no meaningful capacity challenge outside of a couple of names. The good news here, again, TCAF, you get 100 names versus 64 in CAF today, which makes capacity less of an issue. And the other important thing here is, because this product is so focused on tax efficiency, we expect turnover in TCAF to be significantly less than in CAF over time. So, you think about CAF, on the equity side, we might have turnover of 40%, 50% in CAF, whereas in TCAF, it would be more like 5% to 15% over time.

Ptak: Maybe just to jump in—that’s actually interesting to me that the turnover would be lower on the ETF just because I would tend to think given the creation of a redemption mechanism in your ability to avoid incurrence of cap gains distributions, it would actually afford you the latitude to trade a bit more if you wanted to. So, how come you expect it to be less, if I may ask?

Giroux: Sure, I’m happy to. I think there are attractive features of ETFs that allow you to minimize gains. But what I would tell you, first of all, I’d say, one, we don’t have a lot of redemptions early in the process. I’d say that’s one. And there are efficiencies of ETFs, but you can’t eliminate all taxable gains through some of those efficiencies. So, again, we’re very, very focused on trying to make sure that we really pay out almost no taxable gains over time. Again, there are features, but those features are not unlimited, I would say.

Benz: The new ETF spans 100 holdings, which is more than the number you hold in the stock sleeve of the mutual fund version, the traditional mutual fund. So, what’s the rationale for that?

Giroux: Well, first of all, I think we did not want this to be a clone of the CAF equity sleeve, and it’s not. Again, more names, some different names. I think one thing, again, going back to the principle—we don’t want anything to hurt existing CAF shareholders. And so, the existing CAF franchise today is an $80 billion franchise. So, we didn’t want the market to see what we were doing every day in CAF. We just didn’t want to do that. We thought that could hurt CAF. And I think what we also came down to is, what we’re trying to do within TCAF is, the 100 names is really the optimal number of names. It balances the odds of outperformance with the magnitude of outperformance, all while minimizing turnover and maximizing tax efficiency. And the 100 names really is a function of our backtest more than anything else.



2ND EDIT:

I'm thinking part of any benefit to tax efficiency between TCAF and SPY could be due to the approximately 1.5% dividend yield distributed by SPY whereas the T. Rowe Price funds tend to have smaller or almost non-existent income distributions?

[fishingrod]

Good reading. A little late but still applicable.

www.troweprice.com/financial-intermediary/us/en/insights/articles/2023/q4/active-etfs-and-year-end-taxes.html

[Deleted]

another ETF that I have started accumulating, to add some international exposure to my very US portfolio, is CGGO - Capital Group Global Growth Equity ETF
Performance so far is mediocre.

[anitya]

I think it is fine to hold TCAF in a taxable account.

I sold out of TCAF for two reasons: have enough equity exposure to Giroux through PRWCX and if Giroux methodology applies, expect TCAF to outperform by losing less in a down market, which means probably could trail in an upmarket. I am assuming we are in a upmarket. The low turnover (5%?) is definitely the tipping factor for selling out of TCAF.

As a general matter, for me it speaks poorly of anyone who trumpets tax efficiency over S&P 500 ETF. For a mature product like an ETF, why bother trumpet tax efficiency to market - do they have nothing else to set themselves apart? Tax efficiency is expected. I am like, let me know if it is not going to be tax efficient (e.g., the new Bitcoin ETPs). But if an issuer is controlling portfolio turnover of an ETF for tax efficiency reasons, I am out. (Interestingly, it seems TCAF is a transparent ETF - I can see fund holdings as of today. With low turnover, not sure how they avoid copy cats.)

Having said that, not all ETFs are capable of using the AP process for portfolio turnover because of certain liquidity constraints or because APs (sophisticated or otherwise) may not be available in certain markets or not available to the issuer and the issuer is stuck with making cash transactions, potentially resulting in capital gains.

"I have a running argument with M* authors where I maintain that in-kind trading without tax consequences is the main reason for ETF tax efficiency. But M* authors say that indexing is the primary factor for tax efficiency, and then, the in-kind trading w/o tax consequences has an additional secondary effect." Ask M* to look at MOAT - probably one of the highest turnover equity ETFs - it has never distributed capital gains in the past 10 years.

"In 2023, several index funds had notable CG distributions. Reasons were heavy outflows." Unless these ETFs are a different class of their mutual funds (e.g., Vanguard), there is no excusable reason to trigger capital gains because of outflows. I would never buy those ETFs because it speaks more poorly about their business practices.

In summary, any ETF that does not rebalance at a pre-scheduled time is a potential for triggering and distributing capital gains. ETFs that invest in illiquid markets or from issuers that do not have good access to APs can also trigger capital gains.

[chang]

Jan 22, 2024 21:39:40 GMT yogibearbull said:

That looks like a strange claim in TCAF Fact Sheet (BTW, I own TCAF in several accounts now). May be they (the ad people at T Rowe Price, who often write strange copies) meant all funds benchmarked to SP500.

I also bought it, last December. I have a very profitable SCHD holding that I started around ~5-10 years ago; but on closer examination I discovered there were a few tax lots in the red. I sold only those lots to capture a tax loss [talking about a taxable account, obviously] and also because the position was, frankly, getting a bit too large. Where to put the proceeds? I wanted something tax-efficient, 'mainstream', credible, LCB-ish, but not a cap-weighted index (which I dislike). TCAF, which was introduced not long before with much fanfare, seemed like the obvious choice.

I asked about tax efficiency in anticipation of adding to this position.

[anitya]

With Giroux as the manager, I would hold TCAF in a taxable account before I hold any other active ETF in a taxable account.  [That is my advice does not mean I always practice what I preach.  I have some potential tax surprises in my taxable account.]