The Tax Idea That's Scaring ETF Investors

forward by Senator Ron Wyden of Oregon. UM it wasn't initially even in the press release, but uh, it took aim at UH on e t F superpower, which is sort of the tax efficiency that's always been built into UM, the et F structure. Uh So what about that? Uh caught your attention? And then what has been the aftermath in the week plus since? Yeah, I mean there's been a bunch of articles on it. UM and I'll read

to the Wall Street Journal headline. It's pretty basic. It says Democratic tax proposal takes aim at et F s and what they're trying to do is potentially tax the

in kind creation redemption process UM. That process where and we'll go into this a little more, where you exchange the stocks or bonds for shares of the e t F. There's no cash exchanging so ETFs are able to sort of avoid some of the capital gains distributions that mutual funds have to deal with UM, although mutual funds also have that ability, but largely speaking, in any given year, you might find mutual funds have like, I don't know,

six of them distributing capital gains, while only say five percent of e t F do. It's usually in that ballpark. Now that said, you're not avoiding taxes as an ETF investor, you're sort of just deferring them so that when you sell your e t F, you get taxed on those gains. You just don't get a sort of ongoing distribution because

of what other people in the funded. So I've always been to the thought that the e t F was like fair um, whereas the mutual fund, if anything, should be given some relief to make it more like an e t F where your tax based on what you do,

not based on what someone else does. So hopefully we can dig into this, but that's ultimately one of their superpowers because advisors, in particular, when have clients and taxable accounts, really like the fact that they can kind of sort of have control over that when they're taxed so I would still say that low cost, inter liquidity, transparency, those things still make them a viable force even if this

were to go away. But it's a biggie okay. So to walk us through the bill, the e t F industry's reaction to that bill, and then some of the nuances of all things tax, we're gonna be joined by Dave Nadig, who's the director of research at e t F Trends, and Jeffrey Clone, professor of law at Fordham University, whose rees arch on this topic was actually cited by Senator Ron Wyden in the proposed bill this time on trying the e t F S tax nightmare. Professor Cologne,

Dave Nateigg, Welcome to trillions. Thanks for having us, Okay, Dave, I want to start with you. Um, the status quo that sort of Eric referred to has been sort of this this thing that has made the et F special for a really long time. UM. And I want to kind of rewind the clock here to to win this news broke because you were at a meditation retreat um

that was sort of interrupted I think by this news. So, so a what what happened um at this meditation camp whence uh this headline crusted your It was it was as I was on the way out the door, so luckily it didn't interrupt anything, and I was able to, you know, drop in and find my inner piece for four or five days. But uh, you know, this was a classic Friday afternoon press release. UM. You know, which the fine it's industry is just really addicted to dropping

these major ideas on Friday, SIP four thirty. I don't know what it is, um, but you know, the proposal is really pretty straightforward, and and it's actually one that professor suggested in one of his papers, which was just

eliminating a single line of the tax code. Uh A f F T two B sex if I can get it off the top of my head, I'm sure something to correct me if I'm wrong, which is a single line in the tax code which exempts mutual funds both the you know, anything that's a registered investment company exempts them from having to effectively worry about the tax issues of in kinding out um or honestly and kind of in uh securities into the portfolio, which is which is a the though way E T s managed to maintain

net asset value versus market price. Right that that creation redemption mechanism is why e t F s work. UM. Putting a giant barrier for taxes around that, UM could be interesting and problematic. We're gonna get into that, I'm sure, but that was that was the thing that he dropped out there. UM. And you know whether or not that would raise substantial amounts of revenue, whether or not that's fair to investors, fair to the government, fair to non investors,

I think that's probably what we're gonna dig into. And UM, let me just jump in here. You wrote an article about this and you opened up with y R E t S tax efficient. So just as a primer to people who may not understand exactly how they are, could you go through what you expected? Yeah? Sure? So so you know, I think most folks know that e t fs create and redeemed shares pretty much continuously. Uh. A bigger E t F top E t F that's trading every day, you know, like water is going to have

multiple creations and redemptions to day. Uh. And one of the things that the issuer gets to do on a redemption is choose which tax lot to hand back out to the authorized participant. In the process of doing that redemption, and of course they always pick the tax plot that has the lowest basis because that's the one that would generate the most gains if they ever had to sell it. Uh,

And they hand that back out to the AP. The AP because they're a market maker to just chooses to take to mark to market, which is what every market maker does. UH. That that's a choice that they get in the tax code is to either treat trading as an inventory process or as a trading on your own account process. All market makers choose to do that as

an inventory process. So the incoming shares at the market maker come in mark to market and they'll just pay ordinary gains if they then later sell those at a gain, because that's how market making works. The fund doesn't have to book a gain on that lower basis that they handed out to that mark to market UM. So it acts as a form of tax deferral. It's effectively like having a giant four ohn K that is an e t F where you only have to worry about paying

taxes on the way out. Okay, Professor Kloon, I want to bring you in. So everything we've talked about, I'm just curious, why why do we need to change anything? Okay, yeah, no, I think uh Dave lighted out very very clearly the benefits for e t F S a couple of things.

I think the thing that stimulated this proposal UM had had spoken to Widen's office was actually some reporting that was done by you guys at Bloomberg, you know, Zack Mider and Rachel Evans on Basically I call them pathologies, but using I think in what what you know most tax commentators would say is inappropriate way A fifty two B six, Right, They've kind of built on this. Uh, some transactions that you know, viewed from the lens of UH tax person and even even Congress now are are

somewhat abusive, and we will talk about those. Those those are the so called heartbeat trades, right, UM, and I think that's what stimulated the interest UM. And then when they started to look at the potential revenue that that could be raised by this provision. I know that there is a preliminary estimate by the Joint Committee that it's about two hundred billion dollars over the next ten years. Uh.

You know, it's preliminary. I and I'm sure that doesn't take into account, you know, adjustments that would be made. But I think the combination of those two things is like reading about the abuses and I know it's been talked about on the Joint Committee for a while, and then also basically the need for revenue to pay for the other items in the in the in the tax proposals, right, So a combination of those two it kind of brought this to the forefront. Um. Uh and that's kind of

that's kind of where we are today. Go ahead, I just want to I totally remember that article. We actually had Rachel and Zach on the show. I did, I didn't. I think dodge was probably not the right word. I don't know if dirty secret was the right word. That's a debate for another day, but or maybe it is for today. But um, I saw you wrote an article about this before that. That article came out, right, so

my article, let me let me just be clear. My article, uh, it came out in two thousands seventeen, but I it was kind of written in two thousand fifteen. So in the article, I didn't discuss the heartbeat trades. I was just looking at this uh um provision. Uh. You know, even even disregarding the herd be trades and the portfolio adjustments. UH. And I just looked at it and said, I didn't really think it was really sound tax policy. And you know, my my point was that it gave et FU an

advantage over mutual funds. Basically identical mutual funds. You followed the same structure, sorry, this the same UH index, the same investments, but mutual funds will inevitably end up paying you know, whatever we call a d basis points maybe a hundred basis points more a year in taxes. Right, Um, it's not insignificant for long term taxable investors. And so that I kind of looked at it, and I just kind of critiqued it from a tax policy point of view,

and and I didn't really see much justification. So just going back, this provision was originally put in in nineteen sixty nine. Prior to sixty nine, corporations didn't pay tax on distributions of securities appreciated securities. Sixty nine Congress UH starts to curtail that, but exempts mutual funds. So back then it was only s N and open end mutual

funds goes along. In eight six Congress says all corporations are going to pay tax on the distribution of appreciated property after six, but they continue the exemption for mutual funds. It just moves to a different part of the of the code. And so this was out there, you know, in eight six. But stay've kind of noticed that mutual funds is rarely rare for them to make in kind distributions. Uh,

not impossible, but very rare. Most mutual funds, my understanding, is promised to only make cast distributions for up to like two fifty thousand, which covers you know, all all almost everyone's distributions. But uh, what happened was this was there and then the E t F industry I think, uh, you know the person that invented it. Um, this allowed the E t F industry to kind of grow, right

because the creation and redemption process is fundamental. I call it part of the d n A of E t F s because it allows the n a V to kind of stick prettys to the trading price where everyone else is buying. And if it doesn't, people come come in and make profits, and by them making profits, it keeps the n a V uh and market price uh

pretty much in line. That makes it then beneficial for people to be able to buy sell short right options on it UM and it eliminates some of the problems that we had with discounts and premiums and closed in fund right. So closed end funds are almost now kind of a footnote in the history of investment companies UM. And so what we have left are, you know, basically open end mutual funds, which you know we'll throw e

t f s into there as well. But then ETFs now are kind of uh, you know, everyone knows they've exploded, especially you know over the last ten years. We might not be having this conversation if uh we were we were we were a decade ago, from year two thousand to two thousand ten when there really wasn't much gains. UM. So Dave is entirely correct that it's the games, aren't They don't disappear. Uh, it's a ferral. So the shareholders are deferring tax on kind of these uh economic gains

that have arisen at the fund level. And it it's just it's important remember for taxable investors those gains are still there. Uh, they're not going to be UM, they don't disappear However, we know that eventually for deferral benefits mostly benefits higher income people more than lower income people. And then eventually the gains are deferred by for example, death, and then they become forgiven. But that applies to any other game. You're you're hitting the nail right on the head,

you know. I think the there are a lot of things that we can unpack here. I think it is important to point out that e t f s were not designed to be a tax deferral vehicle. And honestly, for the first ten years of the e t F industry, nobody even talked about this. This was really when the advisor started finding e t s as a tool for retail allocations. At the advisor, you know, face of the coal mine, they're the ones that really latched onto this.

I want to say, two thousand three four five when we start did to see that early adoption by UM by those financial advisors early in the context where we are now, I guess, UM, so so whatever designed to be a tax deferral vehicle. However, without that, there are all sorts of unintended consequences. Um you know, the numbers that are getting tossed around about you know, something like maybe twenty billion dollars a year and new revenue that would come in if you got rid of this tax deferral.

I'm very skeptical of that number for a lot of reasons, not the least of which is the industry is very good at figuring out how not to do things like that, right, So I think you would just simply see new structures take place. You would see new investment management philosophies take place that UM that will delay and delay and delay

booking those gains UM. The problems I have, though, are that there's this idea that somehow this is taxing the rich UM, and the evidence doesn't actually suggest that e t f s have really certainly in the last couple of years, when you look at the last few trillion dollars that have showed up in the e t F market, it's pretty easy to point that to the discount brokerage community. That's where that money is coming in. It's coming in from people SWAB and TV and FIDO accounts, their e

trade accounts, the robin Hood accounts. That tends not to be the ultra high net worth investors way of accessing the markets. They're tending to go through private funds, private allocations, uh, you know, other kinds of brokerage accounts that don't show up in those classic discount windows. So you know, the people who are benefiting most from this, I would argue at somewhat unknowable, But I would argue is not the

ultra high net worth investor. It's actually sort of the middle class investor who's managed to squirrel away an extra hundred grand outside their four own k. Right, Yeah, you're you raise, you raise a good point. Um. Uh. My one response might be that, um, if we're looking at this is what the I c I has raised in the last couple of press releases that you know, the average southern median household I think is E t F s are is about a hundred and twenty tho dollars

of taxable income. Uh, and that's certainly not uh not wealthy. How you know. My response would be, let's just assume that this imposes higher taxes on E T f UH shareholders than than now and I think that that that's not an unreasonable assumption. You know. My my response would be, well, those all those households can just put more money into their IRA sep IRA right. The for a household you know, for a very very filing jointly, it's up to about

hundred nine eight thousand that you can put in. That's twelve thousand, sorry d thousand of yearly annual income UH. And you can put in twelve thousand dollars. So if, for example, E t f s became kind of less tax favored than they are now, which is possible, those investors would certainly to me seem to have more room to to just shift into the tax exempt you know investments iras roth IRA's set iras the whole alphabet. But

then they're giving up their timing options. Right. The beauty of the e t F has been you can actually put a hundred thousand dollars away for your kids college, which is in six years, and you can put it away in the SPF A hundred or whatever you want, some balance fund, whatever it is you choose to do, and you don't have to worry about whether or not that's going to get degraded over the next six or

seven years because of fund. All of a sudden throws off a teen percent capital gain because one giant shareholder decided to get out near an institution and therefore the fund had to take had to take the hit. If you look at the higher volume e t f s, the implication of all of a sudden taxing all of these gains continuously can be quite profound. A lot of e t f s actually have you know, full turnover implied by their creation redemption mechanism on a monthly basis.

So if you think about that, what that would mean is that you effectively be constantly making these streams of distributions to investors simply to make the creation redemption mechanism hold for NAV purposes. So you end up taking the n A V tracking function of e t f s and burdening it with the taxes, which I worry could actually unwind some of what we see beneficial about the NAV tagging structure. Just think about the way the e t F works. Shouldn't it be based on your action?

It just it just seems like that, if anything, the mutual fund. Do you want a mutual fund? Or have you ever gotten to capital gains just from just sitting there. It's that, I think, is what really. It's not like the e t f s dodging or getting away with anything. It's almost just like they're making it more fair and whether that was an accident From the early invention of the e t F, again, they were really looking at how to just protect the investors of the fund from

what other investors did. And that is something that Vanguard struggle with a lot early on, and that's why they actually did not let certain investors in the fund. They didn't want to incur costs in the funds. So the e t F externalizes costs, and one of those is your own taxation is on your actions. That just seems pretty fair to me right now. You're you raised a

good point. Uh, sub Chapter M has you know, I hope that at a minimum that UM at least the public discussion of this proposal could kind of, you know, hopefully whatever happens to to this going forward is at least at a minimum stimulate some kind of discussion of how we should kind of rewrite It's it's called sub Chapter M of the Internal Revenue Code, but the rules for taxation of investment company for for some of the

issues that that you you UM and also Dave have raised. UM. Uh, it's you know, it's about sixty plus years uh, and you know, with all of the changes in the tax code. Outside of this with all of the changes and kind of the investment vehicles, it's just kind of a system that's showing it's it's rust. Totally agree, totally agree. Um, Okay, now you know, let's let's just go back to to

your point here. What pends on me you know, unfortunately or or the structure of of uh sub Chapter M is that basically the the investment company calculates, right, it's tax like a corporation. If it doesn't distribute, it's going to pay tax like a corporation. So it calculates all of the investment income, including the gains, dividends, short term gains. Uh. It calculates all that and then it basically can avoid tax by making distributions. Okay, Uh, and uh that's you know,

that's kind of the system that we have. Uh. Your system would be basically basically would make each mutual fund investment into kind of like a big era. Right if as long as I don't sell, it's kind of what we call a consumption tax. Right, as long as I don't sell, so it's call it your four oh one K. As long as I don't pull it out, I don't pay any tax. I'm just not sure we're we're quite ready to go there. And then one of the if we step back, you know, we're trying to kind of

do a lot of things. It's like twist right, Eventually you're gonna fall down. But you know, the the original idea behind taxing investment companies mutual funds was that you'd roughly get you know, it was designed for the small guy to be able to get uh diversification, okay, and then you'd roughly get the same tax consequences as if you invested directly. So if the investment company gets uh,

interest income, you get passed through his interest income. If they get a long term capital gains, they get passed through to you as a long term capital gains. And so if you went to is uh what you know? I know Dave has made this point. Other people have made the point that let's just make sure that if if I don't do anything, if I don't receive anything,

I don't pay any tax. Then it kind of turns it into a big IRA And I'm not sure that we should distinguish, you know, we should give that benefit to investment companies versus individual investing are what Dave alluded to this uh kind of direct indexing that's that's potentially coming down there. There's a big difference because in an ira A, one of the reasons you get tax deferl in an ira A is because you should be making

transactions over time. Right, So if I'm a equity as a thirty year old, I definitely should be selling down some of that equity as I approach. So there isn't there's a societal good and saying, hey, you know what, mr six year old, We're gonna let you sell down some of your highly appreciated stock so that you can do a better thing and get a little bit safer

in your allocation. That's a little different than what we're talking about here with what happens inside in e t F, right, because the main benefit to society of E t F tax deferral is the fact that when those things are eventually taxed, they will most likely be taxed at ay much higher level because all of the gains have instead been embedded into the fund and thus invested on behalf of the government who will ultimately tax them. So there, I get what you're saying, but there is a there's

a different reason for it. In uh in an ira, which is to engender actually useful behavior for society. We're versus the E T F, which I've always argued as like Eric was saying, it's much more about tax fairness. It's much more about not getting hit with the tem per cent you know, you know, capital gains distribution a week after you put your money in, which I've gotten those emails from advisors before, believe me. And and that's

a that's a genuine hit. So there's always this robbing the future to pay for the past, or to robbing the robbing the present to pay for the future, and vice versa, and Washington loves to do that, and you

know that never works out well anyway. Um I what I worry about is simply eliminating the single line item here without as you pointed out, Jeff, a comprehensive review of of all of the implications of this taxation is exactly the kind of hand handed move we get out of Washington all the time that has tons of unintended consequences that nobody has even done the map on right now, I think, and also I think a lot of normal people look at this and they go, Okay, I get it.

Only half the country actually owns stocks at all, so you are looking at just one half of the country benefiting here. I get that a lot of the lower income folks don't get this benefit, and that's that's a fair point. That said, when you turn it relativity in another way, I think a lot of people are like, well, why mess with small investors using e t F. There are much bigger fish to go after on the tax front.

There's a lot of loopholes to go after. So there's also the relativity issue as well, looking at it versus other situations where some really really rich people institutions get away with not paying taxes or just direct indexing, right. I mean that to me would be the immediate impactly at the switch on this, every hundred thousand dollar plus

investor would immediately become a direct investing. Your client end up with better tax treatment than they're getting out of the e t F honestly, because for the most part they'll be able to carry tax losses forward, which is not something the average dollar investors spends much energy on.

So if anything, I'm removing this from the e t F would shove everybody in that sort of mass affluent market out of e t F s, which would be bad for the E t F market, would be bad for individual investors, for whom that is their best option at the benefit of you know, the parametrics and the

canvases of the world. Yeah. No, I I would I would agree that something like this could stimulate uh, you know, I mean, but that that's already on the horizon, right, you know, JP Morgan, Vanguard, black Rock, They're already looking at uh direct indexing direct I call it direct investing. Dave calls it direct indexing right where you would be treated as a holding those shares directly, right, and so you could do the tax loss harvesting. Um, you could

defer the gains. You would make an essence that decision subject to the robot and whatever rules you've set up. Um. And I think that that's an important thing to kind of look at. UM, let's kind of look you know. I think it's important to talk about the real stimulus for this. I think was again the article in Bloomberg and by another financial journalists at Facts, said Elizabeth Kashner that talks about the heartbeat trades, right. Um. And so if we separate just the in and out, here's the

SMP five hundred. We go in and out, in and out, there's no changes. I'm almost you know, saying, well, that might not be a horrible thing, right, If we have no change in the underlying portfolio, fine we we let we let it run, right. Um, And that's that's roughly if I just held the underlying SMP five hundred shairs, nothing change. We just let it run until I, like

Eric says, until I sell. The problem is, uh, these things that are referred to as heartbeat trades, and just for the listener, they're basically is a fund has to sell some of its securities or disposed of them. If it sold them, it would have gain, which should be tax then to all shareholders. Um. What it does then is as reported, is that a market maker a bank will come in and fund will say, oh, I have to get rid of shares that are worth a billion dollars and you know I have a billion dollars of

gain if I sell them. There's a billion dollars of game for everyone. So two days before or three days before someone will deposit, Uh, they'll create a billion dollars worth of shares um with the basket. And then you know at the rebalanced date, A billion dollars goes out to in a redemption, but the shares that go out are not a pearl rata share of all of the UH shares in the SMP five hundred, but the ones

that have the gain. So if you step back and look at this, I think most tax people would say, well, what's really happened is the market maker has just exchanged a portfolio of shares one through four hundred and ninety for a portfolio of shares four five hundred. We just swap shares. I think it's actually worse than you think it is. I mean, if you if you're if you're approaching this as some sort of abuse of the system, there's actually no requirement anywhere in there that that it's

versus one. It can be five hundred and five hundred in both directions as long as there's enough space in between that it can be deemed as having economic risk. So so, But but the problem is is the is

in the US five hundred. That happens every day, right, But my point is there are plenty of funds out there who don't have an exogenous reason to be unloading any of their shares and are simply doing this to watch their tax liabilities away, and they're they're basically doing a creation for a hundred securities, and then they're doing redemption for all hundred securities and they're just swapping the

tax lot. I'm saying, let's assume that that's okay, right, because the underlying portfolio stays the same at the fund level, we get rid of the games. Okay, let's let's just make an assumption that that's fine. My problem comes is when that you're taking out one share ten shares uh that otherwise have gain. You've just swapped one basket for another basket. If you and I did that, Dave, you know it's taxable. If I swap you Microsoft for Amazon,

it's taxable. If I swap you Microsoft for Microsoft, it's not taxable. But our basis would stay the same. My concern is that the heartbeat trades um allow for an e t F, but really not a mutual fund to adjust as portfolio. So me, as an investor in the e t F, my portfolio is actually changing, right. So it's so Eric. It's it's not as if my view

is you shouldn't be able, you should you should be taxed. Now, when those portfolio changes happen if you held the shares and you wanted to get rid of your tenant or fifteen shares, that's a taxable event. But yeah, but but but but that's not KAT, that's just custom baskets. Yeah. Yeah, but we we just we just encoded that in a new law. I don't think we're gonna get rid of that part. Yeah, I see what you're saying. Like you're saying, if you go into a mutual fund, you're a pool.

You're with a pooled it's a pooled investment. So therefore you guys are all that the portfolio manager, you're with them, and you're buying and selling stocks, you should get text. I think generally people though, they don't look at it

that way, and maybe that's the problem. They just see if I buy and sell shares Microsoft, I get tax when I do that, And in e t F is like that where I think people don't go and actually put themselves inside the fund as if they're in this nice little club of people who are all buying and selling stocks together because the PM is doing it, and so all they know is they just get hit with

the tax bill. So I don't know, I think there's I know what you're saying, but don't you think people just are more thinking that it should just be like when you buy and sell a stock on your own. Yeah, but I don't think you should be able to accomplish something through an e t F indirectly what's happening with Dave called them custom portfolios. Yeah, it's just a I call them it even another variation of the heartbeat that you shouldn't be able to adjust your portfolio without having

making it a taxable event. Right. So when Bloomberg reported on this about a month ago when there was a big rebalance, right, was that the Russell Russell three thousand, right, forty or fifty shares? Uh? And and they just reported everyone's doing heartbeat trades, right, And I said, well, wait if I if I'm a share learn Russell three thousand, and all of a sudden, now I have a different economic exposure. Um, you know, I think that that's an

appropriate time to pay tax. So one, you know, if if if if if, if we could agree so on one issue would be if Congress says, well, the in and outs for the baskets, right, a whole basket in and out representative basket in and out. We could nothing's changing, my economic exposure isn't changing. That you know seems to be Uh. I could see making an argument for not

making that a taxable event. But when the e t F s um underlying portfolio changes, uh, and then they use it, they basically swapped those shares for shares from a market maker. I think that there's you know, there's under tax common law that's that's permissible. Dave correctly stated that the SEC allows these custom portfolios. But just because the SEC allows it doesn't mean that they don't determine the tax benefits. So I which that's to me. Then

none of the issue here is right. We now codified a whole bunch of things that when you wrote your paper, you you very carefully go through and point out, these are from exceptions, this is what you know, this is the rule you need an exemption from to do this right. Most of that's all gone away because the f E t F rule. So we cleared up the operational side quite dramatically, and to your point, we've done nothing on the tax side. So the tax side is just the

same as it ever was. Um. It's interesting to hear you say that you actually think the sort of custom basketting issue is more problematic than the full basket heartbeat trading, because the full back basket heartbeat trading is actually the thing that Elizabeth has been writing about and that I think is actually caused the most fear, which is the idea that you can have a non economic activity, i e. I'm going to give you all five hundred, You're gonna

give me all five hundred back in three days. That's clearly not a particularly economic activity that can have huge implications on the tach ight. The reason I'm not as concerned about the entire baskets is you're correct that would lower the game. They're using it just to lower the part cential gain inside the t F. But if E t F never sells, that gain is never going to

be realized. Right. Um. That's why I don't have quite as much problem you know, from you know, it's not pure good tax policy, but I don't have quite as much problem with that because all we're doing is lowering the gain inside the E t F. But but if the gain that never has intractable because how would you possibly track that. Virtually every basket is optimized, like almost literally every single creation basket ever done, has been optimized

at least at one share level. Right, so we talk about replication, but we don't do this in half shares. Every basket is wrong. But but one thing you could you could say is that we have a fifty two b six. This provision continues, except that unless you distribute a if you distribute a custom basket, you get taxed, right. Uh, obviously within reason if you if there are derivatives inside, you can't transfer those within reason doesn't play very well.

And just like there's mostly not a lot of reason and these it's got to proportion them out right. You have to distribute you know, you know the rulings that they've given UH for closed end funds. So closed end funds don't get this rule, right they but the I r S has allowed them in private letter rulings but not not recently UH to get the benefit of this rule.

By the statute, they don't issue redeemable securities, um. And so they just required that you basically have to distribute a proad of share of each security with it with some exceptions, and then a basically a proad of share of the basis right that goes out Um. You know, something like that maybe maybe acceptable. Uh, And then the only thing that would be hit were what are the kind of the trades that were talked about in the

Bloomberg article. Um, again, when there's a taxable acquisition. Uh, you know, mutual funds have to pay tax on that. But E t f s heartbeat their way out of that. And that's something that I I think I don't think that there's much defense at all for that. When that article came out, and you know, one of the things was, well, um, Vanguard, black Rock, these companies look at it as their fiduciary duty to protect their investors. So that would be the

defenses if they don't tax loss harvesting an advisor. This is what all fiduciaries do. No, I understand that argument. But then then the real question is, though what should be the rule? Well, yeah, and I think that's a reasonable conversation. Okay, So, Dave, how existential is this for the E t F as we know it. I don't think it's I don't the only place that could become an existential crisis. It's really messes up the market maker

incentive to do creation redemption. So if if all you're doing is going to the structure of the forty Act fund that is the e t F and saying, hey, you know what, we're going to change the rules a little bit on what you have to distribute out to your shareholders like on the regular that's not that big a deal. If what they instead do is try to come back at this through the AP and market making system, that actually has some really scary implications. Now that's not

what's being talked about. What's being talked about is simply removing this at the at the Ford Act level. Um, it's not existential. I don't think e t f s go away. The liquidity, the access, the cost advantages, none of those get changed at all. Um. The certainly the sort of public acceptance doesn't just reverse all of a sudden.

People don't all of a sudden go back to trying to find an SMP five mutual fund because now all of a sudden they don't get a tax advantage in their sp t F. It would simply put them at parody, and at parody most mutual funds still looks substantially worse, both on a cost basis, attracting basis, like you name it right, just just the fact they have to hold cash to meet redemptions means that in general, most mutual

funds are going to still look course. And and the trend that we've seen and talked about on the podcast before of mutual funds converting into e t s would we do you think we'd see any changes there or you really more funds would continue to become ets. I think the tax advance, the tax efficiency of ets has always been a bit of a nice to have for

some investors. It's a huge deal, right if you happen to be a multimillion dollar taxable investor who has exhausted all of your other ways of squirreling money away, Yeah, the ET has been really helpful for you. But ETFs are increasingly used by huge institutions who don't care about this. They're actually even being used inside a lot of rs and borrowing ks at this point, and people don't care.

They're either um and obviously the hardcore trading community doesn't care about any of this because none of them are holding for long enough for these things to matter. So it's this narrow slice where yeah, they'd really care, but that slice isn't gonna go to mutual funds. They're just gonna direct index. Yeah, and let me jump in here. I you know, you know it's killing Majol do these pans with Dave all the time, and I love riffing off of him. I feel like we could just sit

here and go off for hours. But um, okay, a couple of things. Conversions. There was a version today actually a pot et FU converted to our pot mutual fund converted to an e t F. I don't think that was for tax tax reasons. It had been out performing the pot e t f s and nobody was buying it. I think ETFs are just worth of fisher biting. But I do think the tax could help some mutual fund conversions.

Um that's one feature. Um. I was telling Jroll earlier that tax the tax efficiency of ETFs is sort of like Superman's X ray vision. You know, it's he can still fly, he can still do you know what he does, but he you know, he's he's gonna lose something. And I agree. I think direct indexing is the natural benefactor of those really wealthy people. That's who I think is really gonna just avoid it anyway, is the really wealthy people.

They're gonna But that's part of The problem is the billion dollars were theoretically talking about when it's actually collected in three. Like if you eliminated it today and say, okay, let's take a look in four and see how much money we made, it's gonna be like five, not twenty, because the industry is very smart at figuring out how

to get people out of this situation. And I think, um, who would probably be the biggest loser would be active e t F s like an ARC or a high turnover smart beta e t F because a Vanguard ETF is just not turning over that much anyway. Um, you know, Vogel always said index mutual funds are almost as tax efficient as an e t F even with that special thing you guys have, because we just don't trade so many ways. This is what blows my mind. There's so

many ways around it. You run the whole thing through a twenty percent Cayman subsidiary, it all goes away done. Like I mean, there's so many ways around that problem that if I wanted to run a three active equity fund in an e t F structure and all this went away, I can think of three or four ways that I can do it. Right now inside the four D act that nobody's even talking about. So, Professor Cologne, you've clearly kicked the hornets nest. Are you surprised? Um? Yeah?

And have you have you gotten emails? Like what kind of feedback have you gotten from all this? It's funny this article when I when I wrote it, um, uh, Dave was they would probably laugh. You guys will laugh. Is this is the only article that people wrote me emails about. It wasn't a criticism, but it was like, Oh, my name is uh Joe Smith. I have a ten million I run ten billion dollar family foundation in uh San Francisco. Do you have any ideas and how we

could use this? Uh? Tons of those emails actually, so people looked at it. Oh I didn't know about this? How can I now build up on it? And three three points? Basically, you know, Dave kind of alluded this, and I think Davi would have better information than I would. I don't think E t F s uh. You know, this is a little bit of a roadbump for them. But if we look at the universe of investors, we have the foreign investors, uh, you know, offshore pedge funds.

We have endowments, we have UM pensions, we have four O one case four or three bs that are now allowing purchases of ETF So there's just a huge universe of tax exempt money out there that this is irrelevant. Right, So if any of the listeners say, oh my god, this is gonna I have E t f s in my era or anything like this, this will not affect you one iota, right, And I just think that this,

you know, worse comes to worse. It just makes E t f s a little bit the proper what we call tax clientele where you're gonna be late lyast taxes, the tax exempts will will move more into this UM and then the taxable people may move to the extent that you can away from this now that um. Dave Rais is a good point about the upcoming wave of direct indexing. Direct investing, the heartbeat trades, which allow you to basically get rid of one or two or five

securities without paying tax via redemption creation. When you're direct indexing, you won't be able to do that, right, And so that just kind of tells you if you can't do it directly owning the shares, why should you be able to do it indirectly via an E T F Right. So I'm a I'm you know, I think this direct indestining is a great thing, and allow the tax lost harvesting. Um. But at the same time time for portfolio adjustments, Uh,

they will be taxable. Uh if there are gains, right again, you'll be able to tax loss harvest to mitigate some of that. Knowing what we know about d C and how this has gone down, Professor Colin, what are the odds that you think that this bill becomes a lot I'm gonna say not great because the uh there's eight neutral funds and ETFs are everywhere, so you're stepping on everyone's toes. I would hope at a minimum. Uh, you know, I'm not giving you an answer. I will see what

happens in the Senate. I don't think it was in the House bill on Friday, right, it didn't get in there. I know that the White House is looking at this, but we'll so we'll see what happens in the Senate. I'm I can't give you a percentage, but at a minimum, I hope it kind of stimulates a discussion of how in the US, you know, we can kind of fix the taxation of kind of public investment companies for for everyone. Okay,

try and put some odds on that. Oh I'm gonna I wanna say, under Okay, and and and Dave, how about from your perspective, I think there's no chance that a straight up recision of a fifty two six happens in this Congress. I don't. I would give that essentially zero odds have happened. I think we'll get a bitcoin

et f first. Um. As far as the broader issue, UM, I think if we actually ended up with a I mean to too crazy scenarios, either a clear mandate for one party in every branch of the Congress and White House, which I don't think it's gonna happen anytime soon, or actual bipartisanship to try to solve some real problems. I don't think that's gonna happen anytime soon either. But with one of those two priors, then yeah, I think a full re look at what we do in investment taxation

would be phenomenal because it's a mess. Right. We haven't had substantial look at that since what camera what was s right, that was the last time we actually looked at the tax code and did anything useful to it, in my opinion, and since then all we've done is or poke around the edges as a political football. But the the Investment Task codes at nightmare, and so I'm

all for cleaning it up. Is this repeat? Like, if I'm looking at this massive tax bill, say, I'm like Senator Joe Mansion from West Virginia, who he's got a lot of power, right, and I look at this tax bill? Is that line really? Do I even know what that is? Is that a deal breaker for most people? Or are there other things in the bill that would be deal

breakers and need to be taken out and amended. I'm wondering if the all the horse trading they do doesn't involve this, but this just stays in and everybody's happy and it does go through. I think it's hard to tell. Early on in my career I worked in d c UH and and saw some from the inside some some of the way the tax legislation gets past UH. It's not pretty. That's why I just didn't really want to

give any any predictions. You know. The one thing that kind of keeps it I think a little bit bigger than than day zero, than than Dave's view is is the revenue associated with it a poker full are not imaginary? Not um, just because they're gonna need revenue offsets, right, um, and for the pay for all of this. And so I think in a normal year I would say it had very little chance. But this year I think it definitely has some chance of staying in. That's fair, That's fair.

I have a cruel joke. I have a cruel joke. You mean that has a heartbeat. Eric's Eric's gonna kill me for that. He's way too proud of himself. I can tell I'm looking at him, Okay, Professor Cologne Um. Final question, which is the final question we ask of everyone um on the on the podcast, what's your favorite e F F ticker? Oh e t F ticker? Oh my goodness. I will admit I don't own a d t F uh. We we don't allow them through our retirement plan at Fordham. UM, but probably probably spy. I

have some familiarity with that. And Dave, I think, I know, I think I've heard yours before. But what's your soup? What's the soup? R? I'm still go move van Agri business. I still think it's the I mean for an amount of tia. I mean, come on, all right, Dave, Dave uh, Professor Cologne, thank you so much for joining us on Trillions. Thank you right, thank you, Joel, thank you all right. I never pleasure Dave speaking. Thanks for listening to Trillions.

Until next time. You can find us on the Bloomberg terminal, Bloomberg dot com, Apple Podcast, Spotify, and wherever else you like to listen. We'd love to hear from you. We're on Twitter, I'm at Joel Weber Show. He's at Eric Faltunist. You can find Dave Natick at Dave Natick, and you can find Professor Cologne at Fordham Law n y C. This episode of Trillions was produced by Magnus Hendricks. Francessica Levie is the head of Bloomberg Podcast. Bye.