Key Takeaways:
- All-time highs in US markets may have left family offices with significant unrealized gains in increasingly concentrated public equity portfolios
- When investors exchange a basket of securities for ETF shares under Section 351, gains are deferred and not crystallized, even if the ETFs holdings are entirely different
- The tax basis and holding period of the ETF shares is inherited from the original basket
- Building an ETF is complex and regulated, and will not serve all families equally
What short-term publics markets questions face family offices today?
With US markets hitting repeated all-time highs and mainstream US indices reaching all-time concentration levels, there are two recurring questions facing investors today:
- How do I reduce this unprecedented concentration risk?
- Am I crystallizing my gains at the market peak?
For most investors, these questions soon lead them or their tax advisor to a third question:
- What are the tax implications of reducing portfolio concentration at all-time highs?
ETFs can serve as a unique diversification solution for family offices with diversified portfolios of publicly traded securities through Section 351 transfers.
How do ETFs address these questions for family offices?
Beyond the well-known tax, flexibility and transparency benefits that the ETF wrapper potentially provides relative to traditional fund vehicles, the ETF structure also offers lesser-known diversification and tax deferral applications, providing family offices with a mechanism to diversify low-basis assets without crystalizing tax liabilities. The process can simplistically be summarized into three steps:
- An ETF offers in-kind subscription flexibility such that an investor (e.g., a family office) can convert an existing portfolio into an ETF, as long as the portfolio is diversified, whether that be one or more ETFs, an SMA, or a basket of at least 12 stocks, without crystallizing any upfront tax consequences under Section 351
- Instead of using cash to buy shares in an ETF, an investor contributes a diversified portfolio of listed securities into the ETF following which an investor receives shares in that ETF. The tax cost base and the holding period are both measured at the acquisition of the original portfolio, not at the contribution of this portfolio into an ETF. This defers any gain while also protecting the investor from short-term capital gains
- Subsequent to this in-kind ETF subscription, the ETF can diversify its underlying holdings from those that were contributed without triggering immediate tax implications for the investor
- For example, a diversified portfolio of low-basis technology stocks could be contributed into an ETF in-kind and the ETF could sell these stocks and instead acquire a portfolio of any other listed instruments that it thought represented better value or greater diversification.
Are there other benefits for family offices in using an ETF structure?
The main potential benefits as outlined pertain to diversification flexibility and tax deferral, yet there are other benefits that may apply depending on the investor.
- Fees: Management fees in an ETF can potentially be netted against dividends, interest, and income, implicitly making them tax-deductible and more tax efficient than SMA fees
- Flexibility: ETFs are uniquely flexible in their intra-day trading and transparency
- In-kind: In-kind creation and redemption providers: i) liquidity for redemption that is limited only by the liquidity of the underlying portfolio, and ii) protection from crystallization of gains when other investors divest
- Standardization: ETFs are uniquely standardized in their fee simplicity, rebalancing consistency and reporting requirements.
Building an ETF is ultimately a complex and regulated exercise that most family offices cannot undertake independently. Tema, as an independent institutionally focused active ETF issuer backed by leading institutional investors and industry leaders, is providing Section 351 solutions for family offices to help them access ETFs in a way that meets their tax, diversification and broader investment goals. Tema combines rigor, experience, flexibility and technology to streamline the ETF issuance process and thereby unlock new innovative use cases for ETFs.
For educational use only. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.