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