These ETFs Are Being Seeded with Tax-Free Exchanges

Poof. Where did the tax go?

For their next trick, issuers are turning to a strategy to help seed new products: the 351 exchange, which allows stock portfolios with years of appreciation to be transferred to ETFs without triggering capital gains taxes. But it’s not just the likes of Alpha Architect, Cambria and other shops that have made a point of focusing on 351s. Asset managers are increasingly incorporating the 351 exchange into new ETFs that aren’t specifically marketed for the capability. Advisors should expect to see this much more frequently.

“It’s not something they’re marketing or advertising as a business,” Morningstar associate director Daniel Sotiroff said. “It’s an option they have if they want to launch a new strategy and get it off the ground.”

The Big Money Wins

Over the past couple of years, a handful of asset managers have rolled out 351 exchange ETFs that have had initial investment minimums of $1 million or more. But recently, Alpha Architect added a fund that went as low as $150,000, only for accounts held at Charles Schwab (Fidelity accounts, by contrast, had a $5 million minimum for that fund). In any case, it’s likely that the firms specializing in 351s are moving downmarket, and the tax strategy could be available for smaller accounts. However, the asset managers that have added 351 exchange provisions in several yet-to-be-launched ETFs do not specify the investment minimums for seed money. 

Some of the firms prepping funds with 351 provisions:

• Ritzholtz Wealth, whose forthcoming Goaltender ETF (GTND) will be its first exchange-traded fund.
• Polen Capital, which has filed for a US SMID Cap Growth ETF and 5Perspectives Growth Opportunities ETF, each of which appears similar to existing non-ETF strategies the firm manages.
• Cloverpoint Capital, which filed with the Securities and Exchange Commission for four funds: the Core Alpha US, International, Global and Energy Transition ETFs.

Perhaps the most notable firm to launch an ETF seeded in part via 351 exchanges is American Century’s Avantis Investors, Sotiroff noted. That firm’s Total Equity Markets ETF (AVTM) started trading in late January.

Tread Lightly on This One-Time Event: The rise in 351 exchanges hasn’t escaped attention from Congress, which could restrict them in the coming years. The US Treasury is also considering issuing guidance on such exchanges, according to a report by Bloomberg. The exchanges, which make use of a century-old tax rule, can also be flagged by the IRS, as illustrated by a recent paper on the subject. Further, investors should be fully aware of how the ETF’s strategy may be significantly different from the concentrated stock investments they are transferring, as well as confident that the seeded ETF will gather enough assets to be viable, Sotiroff said. 

“You’ve got to make sure the strategy of the ETF vehicle is actually something you want and are willing to hold over the long run,” he said. “You might wind up with something that is very different from what you were doing before.”