Latest / Masters in Business / At the Money: Deferring Capital Gains on Appreciated Equity

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At the Money: Deferring Capital Gains on Appreciated Equity · Masters in Business

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  Speaker 1: Bloomberg Audio Studios, podcasts, radio news. Let me tell you
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  Speaker 1: how this one for nineteen.
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  Speaker 2: Five tax man tax.
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  Speaker 3: Some investors have big concentrated equity positions that have accrued
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  Speaker 3: big gains. Maybe it's due to employee stock option plans.
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  Speaker 3: Perhaps they have some founder stock from a startup, maybe
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  Speaker 3: there was an IPO or a takeover. But suddenly they
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  Speaker 3: find themselves sitting on an uncomfortably large percentage of their
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  Speaker 3: portfolio in a single name. The challenge for investors is
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  Speaker 3: how can they diversify when selling shares leads to owing
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  Speaker 3: big capital gains? What's an investor to do? I'm Barry Rittolts,
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  Speaker 3: and on today's edition of At the Money, we're going
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  Speaker 3: to discuss how to manage concentrated equity positions with an
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  Speaker 3: eye towards diversification and managing big capital gains taxes. To
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  Speaker 3: help us unpack all of this and what it means
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  Speaker 3: for your portfolio, let's bring in MEB Faber. He's the
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  Speaker 3: founder and chief investment officer of Cambria. The fun runs
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  Speaker 3: fifteen ETFs and manages nearly three billion dollars in assets.
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  Speaker 3: Their new ETF is coming out in December twenty twenty four.
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  Speaker 3: The Cambria tax Aware ETF symbol TAX is a solution
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  Speaker 3: to address just these challenges of concentrated positions. So mab,
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  Speaker 3: let's just start with a basic question. Tell us what
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  Speaker 3: a concentrated position is.
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  Speaker 1: Well, it's a romping, stomping bullmarket.
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  Speaker 2: I know most investors don't feel like it, but a
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  Speaker 2: lot of people have had stocks go up a lot.
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  Speaker 1: Listeners think to two thousand.
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  Speaker 2: And nine the bottom at the bottom stocks have almost
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  Speaker 2: been a ten bagger.
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  Speaker 1: And that's the broad market.
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  Speaker 2: So individual stocks like Nvidia or Apple or others probably.
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  Speaker 1: Have gone up much more.
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  Speaker 2: And the way math works, you end up with a
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  Speaker 2: stock that goes up a bunch. It gets to be
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  Speaker 2: a bigger, bigger percentage of your portfolio, and that becomes
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  Speaker 2: a problem because you're no longer diversified. But so many
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  Speaker 2: investors the response to that is I can't sell it
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  Speaker 2: because Uncle Sam is gonna kill me. The irs is
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  Speaker 2: gonna kill me. Warren Buffett, you know, talks about this
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  Speaker 2: all the time on concentrated positions, and it becomes a problem.
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  Speaker 2: You get lopsided in your portfolio, and then many investors
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  Speaker 2: simply feel stuck.
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  Speaker 3: So let's talk a little bit about what the historical
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  Speaker 3: solutions have been. First, you could pay for a collar
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  Speaker 3: that sort of locks your stock price in. It doesn't
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  Speaker 3: mean you're not gonna pay capital gains tax. Just tells
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  Speaker 3: you if this stock collapses, well, the expense of put
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  Speaker 3: you bought will cover it, but you're still going to
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  Speaker 3: end up owning capital gains taxes. Or some people write
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  Speaker 3: covered calls as a way to offset some of that risk.
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  Speaker 3: You still have the risk that the stock could drop,
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  Speaker 3: or you have the risk the stock could get called
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  Speaker 3: away if it runs up, and you're paying the gains.
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  Speaker 3: Either way, none of these solutions are optimal. Tell us
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  Speaker 3: a little bit about the thinking behind the tax aware ETF.
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  Speaker 2: So, if you go back almost one hundred years and
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  Speaker 2: talk to any real estate investor, one of the ways
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  Speaker 2: they've built generational wealth is the famous ten thirty one exchange,
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  Speaker 2: where you buy a building, you buy a hotel, and
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  Speaker 2: you're able to sell it swap it for a new property,
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  Speaker 2: and that is not a taxable transaction. Amazing right now,
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  Speaker 2: in stocks, there's been something not too dissimilar called the
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  Speaker 2: exchange fund, been around really since the nineteen seventies. Eaton
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  Speaker 2: Vance Goldman Sachs Merrill been putting out a lot of these.
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  Speaker 2: The problem with those, you've got to be accredited or
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  Speaker 2: qualified that means rich, You've got to hold it for
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  Speaker 2: seven years, and usually they're just loaded with fees.
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  Speaker 1: They're set up fees.
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  Speaker 2: They're usually going to charge you a percent and half
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  Speaker 2: a year, and you end up with a portfolio of
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  Speaker 2: just whatever people have contributed. So it's still problematic, not
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  Speaker 2: a great solution. And so there's another acronym, another term
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  Speaker 2: three point fifty one, which is been in the tax
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  Speaker 2: code for almost one hundred years but really hasn't seen
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  Speaker 2: a lot of development until the last ten years, and
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  Speaker 2: then increasingly so with the ETF rule.
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  Speaker 1: And really this concept has been a lot of prior art.
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  Speaker 2: There's been over one hundred of these, first one maybe
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  Speaker 2: about a decade ago, but you've really seen it with
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  Speaker 2: mutual fund ETF conversions, separate account TF conversions. And what
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  Speaker 2: we're announcing is an open enrollment seeding of an ETF
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  Speaker 2: with this three fifth one conversion.
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  Speaker 3: So let's discuss how this works. I'm sitting on a
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  Speaker 3: load of Nvidia or Microsoft or some other highly appreciated stock,
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  Speaker 3: and I want to get defersified rather than sell and
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  Speaker 3: pay the twenty three percent long term capital gains tax.
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  Speaker 3: I could tender these shares to Cambria and they will
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  Speaker 3: use it in part of a broader ETF. So I'm
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  Speaker 3: not selling it and I'm getting diversification without paying the tax.
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  Speaker 3: Explain how that works.
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  Speaker 2: Yeah, so you can't let's say Barry's got ten million
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  Speaker 2: in Vidia. You can't just chuck all this in Vidia
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  Speaker 2: into the fund and see the ETF. What happens is
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  Speaker 2: there's two main rules to qualify. The first is no
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  Speaker 2: position can be above twenty five percent.
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  Speaker 3: Of the my portfolio or of the ETF.
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  Speaker 1: Correct correct of your portfolio.
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  Speaker 2: Second is anything that's over five percent has to be
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  Speaker 2: less than fifty percent.
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  Speaker 1: So you could put in.
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  Speaker 2: Your Apple, but really you probably got to have a
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  Speaker 2: somewhat diversified portfolio.
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  Speaker 1: Let's say you could do eleven stocks. Maybe. Now what's
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  Speaker 1: nice is ETFs are looked.
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  Speaker 2: Through or passed through, so you could contribute Spy or
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  Speaker 2: another ETF. The queues one hundred percent of that because
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  Speaker 2: it's a look through into the underlying companies. But what so,
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  Speaker 2: the concept that we've come to put together is we're
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  Speaker 2: going to gather up all these investors, so individuals, financial
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  Speaker 2: advisors who have clients with highly appreciated stock portfolios, cobble
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  Speaker 2: them all together, put them into this seed through the
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  Speaker 2: new ETF, and after the ETF launches, you then have
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  Speaker 2: that ETF running. It's actually the first of three funds,
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  Speaker 2: and it's going to be sort of a consistent timeline
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  Speaker 2: of open enrollment for the people want to contribute. You
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  Speaker 2: have to contribute to get the tax benefits when the
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  Speaker 2: fund launches, and then you get an ETF and return,
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  Speaker 2: and the benefit is a tax deferral. It's not a
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  Speaker 2: trans taxable transaction from seeding the fund to getting the
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  Speaker 2: ETF in return.
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  Speaker 3: Right, So to clarify this, you're not escaping the taxes,
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  Speaker 3: you're just not paying them until you sell that ETF.
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  Speaker 3: So your cost basis, all those other things just get
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  Speaker 3: transferred to the ETF and on a dollar for dollar basis.
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  Speaker 3: Is that is that accurate?
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  Speaker 1: Yeah?
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  Speaker 2: And it's clear that the ETF structure up and running,
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  Speaker 2: so even if you just go buy an ETF is
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  Speaker 2: a vastly superior structure than a mutual fund marrow. This
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  Speaker 2: summer was saying that just the structure alone in a
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  Speaker 2: taxable count is probably a one percentage point advantage in
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  Speaker 2: an equity fund because you're not paying consistent capital gains.
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  Speaker 2: SPY hasn't paid a capital gain since it's launched in
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  Speaker 2: the nineteen nineties, and on average, the average ETF won't
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  Speaker 2: be paying any capital gains because of that in kind
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  Speaker 2: creation redemption mechanism. So this combines the best features of hey,
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  Speaker 2: seating a fund tax efficiently and then running it tax
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  Speaker 2: efficiently as well.
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  Speaker 3: So does it matter if I'm entering to you a
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  Speaker 3: large cap growth stock like in video, or a small
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  Speaker 3: cap biotech or a mid cap retailer. Are you thinking
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  Speaker 3: about putting together different types of funds different types of
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  Speaker 3: sectors for this.
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  Speaker 1: Yeah.
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  Speaker 2: So the first fund is also a unique fund, and
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  Speaker 2: it's a US stock fund. And we did a paper
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  Speaker 2: about a decade ago. I don't think anyone read it,
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  Speaker 2: but it was about tax optimization with the ETF structure.
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  Speaker 2: Academic literature, there's actually not that much the targets TACOP
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  Speaker 2: optimization that acknowledges the ETF structure. Most of it just
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  Speaker 2: assumes you're in a separate account. And so the ETF
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  Speaker 2: structure allows you to do certain things and so this
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  Speaker 2: fund will actually target US stocks that are value or
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  Speaker 2: quality stocks, but that do not pay high dividends, and
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  Speaker 2: said differently, we want the dividend yield on this fund
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  Speaker 2: to be as close or at zero, because if you're
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  Speaker 2: a taxable investor in my home state of California, your
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  Speaker 2: home state, eight chances are if you're taxable, you don't
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  Speaker 2: want for six, eight, ten percent dividend yields.
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  Speaker 1: You have to pay those every year.
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  Speaker 2: So ideally being able to defer the dividend, turn those
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  Speaker 2: into capital gains and defer them is also a huge benefit.
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  Speaker 2: So that's the first one US stock fund. Second fund
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  Speaker 2: will be a diversified ETF portfolio. Third fund will be
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  Speaker 2: a global stock fund, and then four or five, six
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  Speaker 2: will be whatever barrier requests.
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  Speaker 3: So when you say diversified ETF, instead of tending you
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  Speaker 3: my Nvidia, I can tender my cues and what I
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  Speaker 3: get back in exchange will be a fund of ETFs
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  Speaker 3: and ETF of ETFs.
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  Speaker 1: Yeah, so the cool part is this has been done.
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  Speaker 2: You know, we're partnering with the good crew at ETF
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  Speaker 2: architect It's a bunch of marines. They have that military efficiency.
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  Speaker 2: The last one of these they did for ann auncet
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  Speaker 2: manager had five thousand accounts. Wow, so incredible ability to
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  Speaker 2: Herdkatz put all this together. And so yes, for the
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  Speaker 2: first fun ideally it's mid large cap US stocks, but
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  Speaker 2: you could do ETFs because they're passed through. So if
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  Speaker 2: you contribute spy that's fine because it owns the underlying securities.
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  Speaker 2: If you contribute the queues, I know you still got
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  Speaker 2: a bunch of game stop, you could contribute that, right.
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  Speaker 2: But on the second fund, it'll be more of a
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  Speaker 2: global portfolio. You can't contribute private assets, you can't contribute
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  Speaker 2: your dogecoin, you can't contribute futures options, things like that.
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  Speaker 1: But in general stocks, ETFs or AOK.
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  Speaker 3: So let's talk a little bit about the management of
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  Speaker 3: the actual ETF. When it's US stocks, how do you
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  Speaker 3: figure out what of the tendered stocks you want to
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  Speaker 3: keep and what you want to get rid of. It's
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  Speaker 3: not just going to be random what everybody happens to
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  Speaker 3: present to you. You're going to organize this around some
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  Speaker 3: key investing principles.
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  Speaker 2: I assume everything we do at Cambria is systematic rulespace.
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  Speaker 2: We like to call it in house indexing, and so
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  Speaker 2: this fund will be a quarterly balance one hundred stocks.
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  Speaker 1: And again it's targeting value quality companies.
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  Speaker 2: That pay load to no dividend. And you're going to
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  Speaker 2: see a big c change in the next three to
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  Speaker 2: five years of asset managers and rias optimizing taxable tax
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  Speaker 2: and then non taxable retirement accounts for various type of investments. Look,
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  Speaker 2: they've always done this, We've always done this, but even
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  Speaker 2: to a higher extreme, we've done the math on some
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  Speaker 2: of these high yield portfolios and taxable accounts. And if
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  Speaker 2: you can invest in something like a high dividend yield
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  Speaker 2: fund or a reit strategy, something with a lot of
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  Speaker 2: yield and a taxable count but not pay any yield,
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  Speaker 2: you can outperform on an after tax basis by multiple
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  Speaker 2: percentage points. In some cases it's as high as three.
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  Speaker 2: And so with all this focus on expense ratio, with
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  Speaker 2: all this focus on that just headline, what is the
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  Speaker 2: cost of my fund? Most people ignore taxes, which can
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  Speaker 2: be order a magnitude bigger than a decision to pay
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  Speaker 2: something like an expense ratio. So this fun targeting no
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  Speaker 2: to low yielding stocks maybe not the most marketable idea
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  Speaker 2: on the planet, but something that on after tax basis
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  Speaker 2: makes a lot of sense.
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  Speaker 3: And so when someone tenders either an ETF for stocks
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  Speaker 3: to you, they may or may not end up in
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  Speaker 3: the final ETF. You have the ability to do in
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  Speaker 3: kind exchange. So if you decide to sell it and
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  Speaker 3: replace it with something else, there are no taxes to
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  Speaker 3: either the person that contributed that or the ETF. You're
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  Speaker 3: just swapping Microsoft for Amazon, whatever it happens to be.
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  Speaker 3: That's also a tax retransaction. Is that right?
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  Speaker 2: And this is why so many mutual funds have converted
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  Speaker 2: to ETFs.
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  Speaker 1: So there was one hundred.
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  Speaker 2: Billion of conversions last year. The most famous probably is DFA.
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  Speaker 2: They did about fifty.
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  Speaker 1: Billion of mutual fund conversions.
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  Speaker 2: Is mutual funds, if you have turnover, you're going to
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  Speaker 2: have to pay out those capital gains. And so every
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  Speaker 2: year about end of the year, you get these notices,
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  Speaker 2: here's my expected capital.
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  Speaker 1: Gains in this mutual fund.
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  Speaker 2: And then you look over at the ETF landscape and
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  Speaker 2: you see across the board almost always zero. This is
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  Speaker 2: why we say, to borrow a phrase from Mark and Dreesen,
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  Speaker 2: ETFs are eating the asset management industry. It's simply a
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  Speaker 2: better structure. So Because of this creation redemption mechanism, these
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  Speaker 2: funds can be managed and run tax efficiently with no
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  Speaker 2: capital gains distributions.
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  Speaker 3: Yeah, our preference in the office is the four oh
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  Speaker 3: one k's and four to three b's. If they want
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  Speaker 3: to own mutual funds, they're welcome, but the taxable account
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  Speaker 3: the preference. Anytime there's a choice, we always pick the
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  Speaker 3: ETF over the mutual fund. Those phantom gains are pretty amazing.
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  Speaker 3: So final question. One of the things I'm aware of
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  Speaker 3: is that accredited investors wealthy investors have been able to
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  Speaker 3: do this with separately managed accounts where they're essentially exchanging
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  Speaker 3: highly appreciated stock for a broader, diversified portfolio without incurring
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  Speaker 3: capital gains tax. How are they able to do that
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  Speaker 3: all these years? I know that this is not very uncommon,
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  Speaker 3: but it's taken place for quite a while.
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  Speaker 2: The main tools the exchange fund, which has really been
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  Speaker 2: around since the nineteen seventies. Eaton Vance, Goldman, Sachs, Merrill
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  Speaker 2: Lynch have been doing this for their accredited and qualified clients.
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  Speaker 2: You got one hundred million of Tesla, you can submit
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  Speaker 2: it to this fund. You get one hundred of your
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  Speaker 2: buddies to submit their stocks. You end up a portfolio
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  Speaker 2: of what everyone's submitted, but the rules are you have
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  Speaker 2: to hold it for seven years. You end up with
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  Speaker 2: just whatever these people have contributed. Usually it reflects the
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  Speaker 2: SMP or the cues or something like that. But the
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  Speaker 2: biggest problem and across the board, and there are massive fees.
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  Speaker 2: There's fees to set up the fund. There's usually the
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  Speaker 2: management fee is a percent and a half or two
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  Speaker 2: percent per year on average, and then at the end
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  Speaker 2: of it you get distributed those stocks. So not the
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  Speaker 2: most ideal situation, maybe better than sitting on a constant
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  Speaker 2: ty a portfolio. But the exchange fund has been around
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  Speaker 2: for a long time for these are credited qualified investors,
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  Speaker 2: and we're trying to bring this to the masses and
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  Speaker 2: make it hopefully available for anyone.
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  Speaker 3: So last question, it's a fascinating idea. I know your
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  Speaker 3: colleagues over at ETF, architect Wes Gray and others. How
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  Speaker 3: on earth did you guys come up with this?
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  Speaker 1: So Wes works with a lawyer named Bob Elwood.
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  Speaker 2: We did a podcast with Wes and Bob in February
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  Speaker 2: this year that did a deep dive on three fifty
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  Speaker 2: one transactions, because like yourself, I wasn't that deeply knowledgeable
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  Speaker 2: about this phrase.
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  Speaker 1: I had never really heard it before.
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  Speaker 2: But it turns out he did the first one a
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  Speaker 2: decade ago, and he's done about one hundred cents.
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  Speaker 1: I was chatting with folks at Nasdaq.
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  Speaker 2: They said, there's been multiple hundreds of these, but usually
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  Speaker 2: it's a closed door. Hey, I have a fund, or
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  Speaker 2: I have a couple counts here. It's going to be
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  Speaker 2: my clients, our innovation. That I said to Wes, It said, Wes,
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  Speaker 2: why can't we do this? Why can't we open this up,
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  Speaker 2: open enrollment to everyone to contribute, And he says, I
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  Speaker 2: think we can. Man, but again, you need that military
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  Speaker 2: efficiency of all these marines at ETF architect to be
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  Speaker 2: able to cobble together thousands of accounts and keep this
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  Speaker 2: available to everyone, which should be the first of many funds.
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  Speaker 3: So to wrap up, investors with concentrated equity positions that
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  Speaker 3: have appreciated a great deal should consider a form of
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  Speaker 3: diversification that doesn't force them into Uncle Sam's arms. That's
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  Speaker 3: any form of three point fifty one exchange. So perhaps
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  Speaker 3: the Cambria taxaware ETF tick or tax might be a
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  Speaker 3: solution to address the challenge of your concentrated position. I'm
• 16:42
  Speaker 3: Barry Rihults and this is Bloomberg's at the Money tax.
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  Speaker 1: Tax.
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  Speaker 3: Don't ask me what I want it if you don't
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  Speaker 3: want to pay some