The Heartbeat Trade

from the E t F world I operated. There was a lot of pushback comments, which will address today. But all in all, this is something that I've seen on my screen for h I don't know, at least five eight years maybe, and it it's it's sped up lately more recently where you'll see a flow come in and it'll be a pretty big spike on the daily flow screen, and then two days later or a day later, the same exact flow comes out. And they were dubbed heartbeats

because they kind of look like a heartbeat monitor. Um and essentially they can throw you off. For example, sometimes you'll see a bunch of heartbeat flows come in right at the end of the month and they count to like, say March flows, and it'll be like, oh, March was a record month, and then where you'll say, oh, value had a huge run in, and really it was a heartbeat flow. So for me, over the years, I've learned to sort of tease them out to try to access

true sentiment because they are not sentiment. They are an operational type flow. And the reason that we want to talk about it this week is that taxes are kind of on everyone's mind because April and there's some tax implications to heartbeats, So that's why we want to talk about it this week. Joining us Zach Minor with Boomberg News as well as Rachel Elements this week on trillions the heartbeat trade controversy. Zack, welcome to the show for

the first time. Actual you're a regular, Zach. How did this story come about? I used to write about taxes a lot, so I know you actually like when a pulitzer for writing about Texas, right, I did. That's kind of a big deal. Congratulations, Thank you. What was the story on that you wanted for? It was about um companies that acquire a foreign address to no longer be Americans so they can pay lower taxes tax exactly. Yeah, like Apple. Uh, they didn't do that, but they did

a lot of other interesting things other taxes. For sure. They're the ones who had the Irish company that was that was a tax resident of nowhere. It was the Irish thought it was American and the Americans thought it was Irish, so it was a tax resident of of nowhere. Very true. So you know a few things about Texas well. I know a few people. I stayed in touch with a few people, and one of them mentioned last year, you should really write about this thing, uh in the

E t F world. And I know nothing about E t F s. I barely even knew what et F stood for. And so I can't take trillion, yeah exactly. So I can't take to Rachel, who knows everything about ETFs. And she kind of um explained, you know, using small words. She kind of helped explain it to me, and we decided to try to look into this topic. Yes, So, so that came to me back in January I think

it was of this year. And like Eric mentioned in the intro, we've seen rebalances in the ECF industry for years, and to his point, there's something that we really watched out for, because when we're writing about sentiment, they tend to throw us for a loop. They they send us kind of like going in the wrong direction, saying that everybody is suddenly bullish on financials, when in fact that

money is going to come out a couple of days later. However, what I hadn't realized, obviously not knowing everything about the et F industry, was quite kind of how important these

trades are for tax purposes. So Z came to me with this kind of sort of idea about kind of how these were effectively kind of like tax motivated transactions, and we started to try and kind of piece together exactly how these trades really work, whether they have a real well kind of implication in terms of like the shifting and stock within a fund, or kind of like well, I guess, and exactly how that impacts the tax for those funds and for their end investors. So what exactly

is the heartbeat trade? Typically, you know, most ets follow indexes, and every once in a while the the index changes, you've got a stock that has to leave the index or come in. And if an et F just sells the old stock that's leaving the index, and that stock was a winner, like it went up during the time the et F owned it, that would generate a taxable gain which would have to be passed on to et

F investors. And so the alternative is, if you and the people who know e t F s know about the creation redemption process, if you happen to have people who want to redeem that day enough volume, you can just hand off that stock to them and there's no tax implications. And that's because of this this kind of strange little except and to the general rule in taxes that was that only applies to mutual funds and ets, and and what's the history of that exception. So in

nineteen sixty nine, Congress decided to make it. Uh, the general rule be that if a corporation essentially buys back at stock in the form of giving over appreciated property, then they would have to recognize tax on that appreciation. And they made it. They carved out an exception that only applies to regulated investment companies, which is mutual funds and ets. But back then, of course, there weren't ets.

There were just mutual funds, and at the time, no one really thought it was a big giveaway because mutual funds hardly ever do this. They only use it kind of in emergencies, So nobody really paid much attention to this weird little exception that hardly ever got used. Decades later, ETFs come along, they use it all the time. They're kind of set up to operate that way, and so it's a it's kind of the source of e t F s um kind of durable tax advantage over mutual funds.

And you know, this rings to our documentary shameless Plug on how the e t F was created, And remember Kathleen Moriarity saying they didn't make the creation redemption mechanism for this purpose, but the lawyers, the tax lawyers, informed them that this is going to be a nice, happy accident that you would be able to limit your capital gains. Happy coincidence, I think. And it's called the e t

F story, what I just call it. Just didn't put the title out marketers a little bit, uh, But part of that was that you know, this is totally legal, right, like, this is something that the e t F hasn't It's not like it's exploited but it's taken advantage of So what is there anything actually nefarious going on here? So yeah, so I just started to say like half the story

of what a heartbeat is. So normally et f s are creating and redeeming, and whenever anyone redeems, they can kind of because they're redeeming in stock they can use. They can hand over appreciated stock. They can look through their invent tory and find the most lowest basis stock, the stock they bought for cheapest and hand it over every time there's a redemption in just the natural creation redemption process in the et F that's the normal way.

But what if you have a big stock leaving your index on a Friday and you don't happen to have a bunch of people you know are going to redeem that day. Who knows, maybe people want to create that day. Um, that's a problem because if you sell again, you're gonna create a taxable gain for your that your shareholders will have to pay. But what if you could somehow magically create more extra redemptions that happened just at the time you need them, so there's no tax bill. And that's

what a heartbeat is. You call up a market participant UM, a bank or or a market maker, an authorized participant in the e t F LINGO, and you say, hey, listen, I've got this redemption I need to happen on Friday. Could you please create on Wednesday? Create this amount and the banker market maker will create a whole bunch of ETF and then a day or two later redeem out.

But rather than redeem just the custom the standard basket of all the stocks in the e t F, they'll take the stuff that the et F needs to get rid of that day. And that's why the question about whether this is kind of nefarious or not really comes in. If this is part and parcel of kind of like how an et F operates day and day out, that's one thing. But then when you're synthetically creating a transaction for that purpose to get rid of those those specific stocks,

how does the I R S? How does Treasury? How does Congress and the American public feel about that? Eric? When when you see that on a screen, what does it look like to you? Looks like a heart monitor, It looks you know, I call these operational flows or tax flows. UM. It's interesting because this idea of maneuvering around the I R S happens like everywhere, every industry

does this. I think some of the initial reaction the pushback was basically that um, typically when something to farious going on, little guys getting screwed, and here the average investors benefiting from this practice. I think that if you're an investor in e t fs via anything, you're actually probably benefiting from this in the form of not actually having to pay those capital gains. Right, well, let's talk

about dodge versus deferral. Can you just break down this isn't avoiding the tax, it's more just putting it off, right, Yeah, absolutely, So if an e t F doesn't distribute capital gains to its shareholders, that doesn't mean they'll never have to pay. It means that rather than paying every time a stock leaves the index every year they own the e t F, they get to sort of save up all those tax bills till the end. They get to wait until they actually sell the e t F and then pay them

all at once. But there's so first of all, there's you're essentially getting a no interest loan from the U. S. Government that you control when when the loan is due, right, so that's like obviously a cost to the government. If I call the I R S and said I don't want to pay my taxes for ten years, they would throw me in jail. That's not okay, right, So that first of all, that it's it's it's deferral, but that deferral is a real thing. The second thing is there

are cases that are where you don't pay. The first is if you if you leave the e t F in your state, your heirs don't have to pay that capital gain it disappears. The second one is that some of the gains that are generated by an e t F buying and selling stocks are short term gains that are that are paid at a higher rate um than long term capital gains. But by the magic of this process, you're transforming them into long term gains that are paid

about half the tax rate. Now that's not a big number for most CTFs, most of their gains are long term, but it's not zero either. Obviously, the the investors you do benefit from this maneuver, if you want to call it that. But I think the other things kind of remember is that when we look at sort of the American population at large, the vast majority are not investors. Your investments are still managed by a relatively small proportion

of the overall public. So if the treasury is effectively giving a loan to investors for this purpose to defer tax for a certain number of years, there are other things that treasury cannot do with that money. They can't invest in in your children's playground, for example. They can't necessarily give out food stamps to the poor. There is something that kind of like goes from actually having this this defer or there's something that this money could be

put to which is not so. Yes, the small investors do benefit, but you've got to be an investor to be able to benefit. And how much money are we are we talking here? So in the by our calculations, in the most recent calendar year for e t f S, we found over two billion dollars of capital gains that

were essentially uh not recognized through this process. So if you were to do the math on that, that's maybe twenty some billion dollars of taxes that essentially weren't paid that year and that will be paid instead some year in the future. And so in the next year there will be another loan by the government to these investors

of twenties so twenty or so billion dollars. And there's a lot of ways in which the government um encourages savings and offers tax subsidies two savers like through four owen k's and I ra s and savings vehicles like that. But those were the product of some kind of policy discussion in Washington where Congress said, we want to encourage this kind of savings and not that kind of savings.

This one is just kind of happened by accident. No one, no one even really kind of knew in Congress that they did it, and so we thought it was worth pointing out so you can have that policy discussion about is this the kind of subsidy we want to we want to impose UM just on et F holders, not mutual fund holders, not hedge fund owners, not people who in individual stocks, just E t s. And this idea of tax maneuvering we saw this year in January weren't

heartbeat trades, but a ton of money came out of equity E t F s unnaturally, and in Q four a ton of money went into equity E t F s in the face of a downturn, unnatural that was tax loss harvesting, and an advisor would advertise they call it tax alpha. And one argument that was made was that the advisor is being fiduciary by helping their client steer around that. Could you make the argument the asset manager would not be would be violating their fiduciary duty

by not taking advantage of this. I think that's a totally valid argument. I mean, I don't think it's at all. You can't really blame the UM the market participants here for doing what they believe and their lawyers are telling them as legal and that clearly benefits their investors. There's

no question about that. At least they're taxable investors UM and so, uh, you can't really you know, cast moral you know, aspersions on folks who are trying to follow law and you know, maximize the tax of sency of their funds. But it's also worth kind of pointing out, what are the policies that were created? Did anyone ever intend this subsidy to applied to this one particular industry

and not others? And you know, if we were to kind of take a look at the tax code, is that really like the way it's it's supposed to work. I think that's our point. I also want to point out that the term of heartbeat wasn't one that you guys coined. The first people to recognize that this was happening. Um, So who coined it? And what happened since she discovered so?

Elizabeth Kashner at fact Set Research wrote about this in December UM and she it reminded her of the flows on the screen, reminded her of her of her dad's e KG monitor. That's why she called them heartbeats. UM. That research was was great and really gave us kind of the foundation of what we you know, pursued um UM. But you know, outside the et F industry, I don't think a lot of people, um had really heard about it, which was why we thought there was an opportunity to

tell tell the story more people. Yeah. And these these trades also have a lot of different names within the industry, which may give you a sense of how people view them. You know, they're often called friendlies or kickers or tax trades. That the more kind of like politically correct term these days as custom in kind baskets or SIPs. It's like the lawyer, Yeah, the lawyers, the lawyers. Basically, the lawyers told them not to use all those other terms because

they they kind of they're a little too truthy. The problem for the lawyers is that they want to pretend that these are kind of third you know, arm's length transactions with the banks doing them for their own reasons, but they're really not. And so a word like friendlies set off alarm bells. So now that they they instead they use this word custom in kind baskets that doesn't really mean anything and no one can remember, but it

it um they think is safer ground legally. You know, I think if I was the I R S the government listening to this, you know. One of the things that really just upsets people about mutual funds and I get it is hey, I bought this mutual fund and I'm just sitting there like a good soldier, and I get this nasty tax bill because somebody else left. That really is not fair. The e t F sort of seems fair, not like like you're cheating, but fair. You

pay a tax when you sell um. So if anything, I think the mutual funds should be fixed or we're dealt with to make it like the e t F level playing field. That that's just my opinion on it, because that idea of just sitting there and getting a tax bill because you invested in a fund, just I don't know, something seems kind of wrong about that, especially because you're basically paying taxes because somebody else did something.

So judge truth, judge everything on this one. So I feel like I kind of have a pretty good sense of what people in the industry have said, and we'll get to that in a second. But what have you heard from policy makers since the article was published? So far? From my side and Za can probably speak to this better, it's been to be relatively quiet in terms of the wider reaction. You know, obviously the industry has been relatively defensive in some in some respects, and I think that's

entirely understandable. You know, this is obviously something that has helped the E T F industry grow into this three point eight trillion, you know, sort of size beasts that we see now in the US. So it's obviously something that people feel quite strongly about and and see as being very investive friendly in terms of kind of like the wider reaction, though, you know, from the general public, you know, I have had quite a number of emails and comments sort of saying that they're glad that we're

shedding a light on this and asking these questions. Some of those maybe investors that have benefited from it, some of them are not. But I think you know that the point of all these types of stories is really to to provoke a conversation and get people kind of talking about it. Two things I thought fascinating about this if you go deep to the end of the story, two things jumped out at me that we're just fascinating.

One is that the SEC is sort of putting into their new rule to make this easier for smaller players to do. In a sense, they're helping helping the industry out. There's the SEC, and then the I c I, which is the biggest mutual fund lobbying organization, which, if anybody would might benefit from this loophole getting closed its mutual funds right because E T f are so much more tax efficient, They've driven a lot of investors away from

mutual funds. It's one of the reasons. And the I c I is basically saying this, you shouldn't close this loophole. It would it would force our frequent sizeable and unanticipated tax bills. I thought those were interesting defenses from gigantic bodies that you would almost think have a vested interests on the other side, to close the loophole, so I

can take the Securities and Exchange Commission first. Mean, so the rule you're referring to is what we call kind of colloquially the e t F rule, and basically that's been in the works for the last decade or so, and the idea is to effectively kind of streamline the process by which e t f s are able to

come to market. That's its overall task, but one of the proposals within that is designed to make it easier, particularly within fixed income e t f s, to create more liquidity within those e t f s and to allow peop to create and redeem those more easily. As part of that, the SEC plans to allow custom baskets, which is something that's very much been a part of

kind of this heartbeat trade. You need to be able to give out something that's not a pro rat slice of the fund in order to be able to give out securities that there are are going to be taxed at that the highest level. So this is something that we will have that implication, but I don't think it's necessarily the intent for having read that the rule as

it's been put out there. But I think the SEC is definitely aware of heartbeat trades, and to our knowledge, they haven't come out and slapped any risks about them or or commented praising them either. Yeah. And as for the i C, I mean, they do represent et F companies, so if you talk to mutual fund managers, some of

them are are livid about this, this heartbeat situation. And I think the i C s comment there was not defending heartbeats, but defending the underlying tax benefit that does apply to mutual funds in a much less attractive way and saying that you know, the tax and benefit that the e t F E t F to use every day shouldn't be repealed. So, Eric, what's been the reaction within the industry, I think mostly defensiveness. I think you know um Rachel's point earlier I think is key here.

If you're looking at society as a whole, there's a huge argument this is why the FEDS policies, you could argue, are creating income inequality, because they're just helping asset prices go up, and if you don't own any assets like stocks, bonds, that you're kind of missing out on this whole bonanza. And e t f s are part of that. And

anything that helps people who own stocks, it helps. But if you take just the owners of assets and you bubble those off and put the rest of society aside, I think most of them are like, hey, this is the retail investors benefiting here. Um, this is nothing new. We've heard about this. I can I can see both

sides for sure. I do think there's somebody Quota who said the fact that they got a little they sped up the amount of heartbeats they got bigger, like, maybe they shouldn't have taken advantage so quickly, so fast, because it does look a little uh, not greedy, it might not be the right word, but maybe a little yeah, because back in the day, I don't recall hardly any of these maybe once in a blue moon, but they're

pretty routine now. And one other point was made, which was Vanguard now everybody knows them is sort of the you know, Jack Bogel, the champions of the little guy. And they're probably, besides black Rock, the biggest company that does this, and so I think that also the biggest right. So what do you guys make a Vanguard being involved? What do they say? Um, you know, they they commented

for a story. They said that they've they believe they're in full compliance with the rules, and they defend the practice and and to be to be fair, I mean, Vanguard's whole mantra is low fees, low taxes. Uh, and this fits right into that. It fits into you know, let's do everything we can to put the investor first. To your point about how this has become more more common, you know, I think that's that's not just kind of

an illusion. That's definitely true, you know, based on on the data that we looked at, and that really speaks to Hannah how fast the E t F industry has grown. I mean, if you look at kind of like assets, you know, we're now at three point eight trillion. You're a decade ago we were under one trillion. So it's become very very big, very very quick. And many of those new funds that have been garnering assets are those

that rebalance much more frequently. If you look at the older E t F you know they're maybe doing twice a year, once a year. They don't need these so frequently. We now have funds that rebalance once a week. If you're rebalancing once a week, that tax kind of a burden from having to book attacks every time you are

are changing your portfolio could be pretty severe. So being able to capitalize on this this this part of the tax code allows you to have those funds, and they have been kind of like the ones that have really been growing, these kind of like smart beta factor focused funds. So I think that's kind of like one of the reasons we're seeing more and more of them now and why it's become such a kind of interesting feature, and

perhaps you know, we see that much more frequent. The other thing, of course, is that we've had, you know, the longest bull market in history. So if you've got stocks always going up, you're gonna have an awful lot of gains there. Yeah. And and to that point, one of the e t s back in the day that gave off nasty capital gains because it had no other choice was FM, the frontier market. It had this incredible

run up. And that's true if the market were to be more normal, less fed induced, and less utopia like uh, and had you know, went up and down, I think this would probably come out naturally. You guys pointed out that Spy in particular was able to do this naturally for a number of years. Right, we don't. I mean they may. There's a couple of times they might have

done a heartbeat. We're not really sure. But for the most party, that's the biggest etf the most heavily traded stock in the world, I think, right in the US, and and they have so much natural creation redemption they don't need to kind of create synthetic redemptions in order to do these kind of UM changes in their portfolio. That's a good point. And Vanguard sees nothing but influence for the most part. And that's the problem inflows. Plus, a rising market means you you're going to have a

capital gain unless you maybe do this UM. One other issue here is that the other participant isn't the asset manager. It's the banks, right, the authorized participants, right market makers. So here's the quote from Vanguard. The question was what do they get out of it? Because isn't the real deal that if it's a tax violation, whatnot? If it's done for the sole purpose of dodging taxes versus the

party has a reason to do it right. So here's what Vanguard said, Um, the banks enter these transactions for their own independent business reasons. That's all they said about it. But what what what what did you guys find out

about I found that nicely vague. I mean, independent business reasons cover a multitude of different possibilities, right, I mean what what we heard from talking to people and we you know, we did talk to tens tons of people about this story and was really kind of the when it comes to what they're getting out of it, this is primarily done for relationship reasons. Banks are able to as as authorized participants, are able to kind of hedge

these transactions. They may even be able to kind of trade with some of the securities they get out at the end of the day potentially have optimized their headges to get a little bit of upside. But by and large, these are pretty much trades where they break even and they're doing it because they want to get more business from these asset managers. It's my favor. It's a favor exactly, whether it comes to ets or it kind of translates

into maybe their active management a sphere. They're doing this because it helps out somebody that they want to get business from in another respects. So I guess independent business frees and stuff that falls under that for sure. We're a whole episode called good Guy right there. Zach Rachel, thanks for joining us, Thanks having its, thank you, thanks for listening to trades Until next time. You can find us on the Bloomberg Jomnal, Bloomberg dot com, Apple Podcast, Spotify,

and wherever else you'd like to listen. We'd love to hear from you. We're on Twitter, I'm at Joel Webber Show, He's at Eric Baltunis and he can follow Zach and Rachel at Zach Miners and at Rachel Evans. Underscore and Why Trillions is produced by Magnus Hendrickson. Francesca Levy is the head of Bloomberg Podcast. Bye