Why the $5.4 trillion ETF market faces its biggest crisis since inception

Happy Thursday! Exchange-traded funds have been referred to as one of the best financial innovations and the greatest success story in markets over the past few decades. There are many solid attributes to ETFs that are enjoyed by individual investors and institutions alike but one important benefit, the tax efficiency, could be stripped away from the funds, delivering a potentially blow to the industry experts told ETF Wrap.

We're going to talk about the implications of a proposal coming out of Washington, D.C. that has raised the hackles among large and small ETF providers alike. We'll also touch on a new ETF on offer by Goldman Sachs that our colleague Christine Idzelis is reporting on.

As per usual, send tips, or feedback, and find me on Twitter at @mdecambre to tell us what we need to be jumping on. Sign up here for ETF Wrap.

The good and the bad

An ETF death knell?

U.S. Senate Finance Committee Chairman Ron Wyden's proposal aims to tax the ETF industry. As our readers well know, ETFs are a baskets of securities that are as easy to trade as a stock and appeal to average investors for its convenience if not also for its tax efficiency.

ETFs avoid taxes with so-called in-kind transactions.

The inherent tax efficiency of an ETF, which usually is constructed to mimic the performance of index and tends to be low-cost for that reason, is the direct result of the in-kind redemption of shares and creation of new ones. Currently, in-kind tax treatment is governed by section 852(b) (6) of the Internal Revenue Code, and provides that the creation of new ETF shares and the redemption of old ones isn't a taxable event.

The process by which this occurs is complex and involves Authorized Participants, or APs, and market makers, but ETF Trends explains it best here:

Wyden's current proposal. however, would result in funds passing on capital gains to millions of investors in ETFs, a rapidly growing segment of the U.S. market, boasting some $5.4 trillion in assets, as of the end of 2020, according to CFRA data. Mutual funds. meanwhile, with $20 trillion in assets, often pass along capital gains incurred throughout the year as they sell stocks or bonds to raise cash and meet redemptions.

Industry lobbying group the Investment Company Institute, or ICI, in a Wednesday letter explained that "the tax code's treatment of funds' in-kind redemptions helps prevent investors from incurring unexpected tax bills triggered by other investors' actions," but adding that the current rule "still ensures that fund investors pay all the tax that they owe when they ultimately sell or redeem their shares."

Todd Rosenbluth, head of ETF & Mutual Fund Research, told ETF Wrap that the proposal if it gains further traction and becomes a law would "be harmful to many Americans."

"The ability to limit and often avoid passing along capital gains to existing shareholders is one of the important benefits ETFs typically provide in addition to intraday liquidity, low expense ratios and daily transparency," he said.

"If ETFs no longer can utilize in-kind redemptions and loyal shareholders are taxed at year end for fund activity it would be a burden to many middle class investors," Rosenbluth said.

Behemoth ETFs were up in arms over the proposal, which started to gain attention last Friday, one insider said.

Invesco, one of the U.S.'s biggest ETF providers, said through a spokeswoman via email that the company "strongly disagrees with the premise of the proposed legislation and believes that instead of resulting in additional taxation for the 'wealthy investors and mega-corporations,' it will actually hurt 'average' taxpayer that Congress is trying to protect.

WSJ wrote that the proposed in-kind transaction tax are expected to generate $200 billion over a decade, based on estimates by the Joint Committee on Taxation.

A call to Wyden's office on Thursday wasn't immediately returned.

The battle is on

Proponents of ETFs make the case that those funds have democratized access to the market, giving investors of all stripes the ability to gain access to areas and strategies that they would not easily get access to without paying hefty fees.

Invesco makes the case that more than 50% of those born between 1981 and 1996 consider ETFs the primary investment type in their portfolios.

Industry participants also argue that ETFs are being billed as an investment tool that solely benefit the wealthy. Advocates of ETFs also note that longer-term holders would likely see the greatest harm under the Wyden proposal.

"ETF shareholders mostly realize capital-gains taxes when they choose to sell their shares, so without protecting in-kind transactions from taxation, long-term investors would be hurt when others sell," Invesco wrote in a statement.

BlackRock, a fund behemoth, said that the "in-kind" taxation proposal raises concerns for them.

"We would be concerned about policies that would raise costs and reduce returns for long-term investors and retirement savers, and are carefully reviewing Senator Wyden's proposal to better understand how it will impact millions of long-term investors," the company said.

The ICI explained that Wyden's tax proposal is more harmful to ETFs than mutual funds, which also use in-kind redemptions and creations, because they do far more in-kind redemptions.

"ETF shares are created and redeemed in large blocks in transactions between funds and large financial institutions known as authorized participants," the ICI statement notes.

ETFs are dead?

Dave Nadig, director of research and CIO at ETF Trends, ETF Database, told ETF Wrap that although the proposal, if it is realized would represent "a significant blow to the advantage ETFs have traditionally enjoyed vs. mutual funds," he sees ETFs still maintaining a number of benefits.

Those benefits include "generally cost, flexibility and tradability, transparency," wrote Nadig.

"So it's hardly a 'ETFs are dead' situation. It just removes one particular advantage," Nadig said.

That said, while wealthy investors may be able to deal with the proposed tax changes, average Joes and Janes would be saddled with the burden of paying the added costs.

"I get that it's an attractive argument that we're 'taxing the rich' here, but honestly, the ETF brought a clean, well understood tax-advantaged structure to any investor with $100 and a Schwab account," he said.

"High net worth investors have always had access to structured products, LLCs, pass through entities and countless other structures to avoid near term gains inside a defined trading strategy," he said.

Who owns ETFs

According to the ICI, nearly 12 million U.S. households own ETFs. The median income of these households is $125,000 and 92% of all ETF-investing households make less than $400,000.

Goldman's Cathie Wood killer?

Goldman Sachs just launched an ETF targeting the next generation of technology companies, outside of the most popular companies already being bandied about. The fund sounds similar some of those on offer from Cathie Wood's roster of ARK Invest funds and perhaps is intended to take some market share from ARK with a target on lower-profile companies.

MarketWatch colleague Christine Idzelis reports that the actively managed Goldman Sachs Future Tech Leaders Equity ETF (GTEK) will invest in listed companies with a market value of less than $100 billion and the fund will trade under the ticker symbol "GTEK."

"We're now at a key inflection point where that innovation is expanding beyond the U.S. and down the market-cap spectrum," Sung Cho, a GTEK portfolio manager told MarketWatch.

A number of fund providers have been attempting to ride the wave of new, groundbreaking technology. Less than a month ago, so-called The Future Fund LLC launched the actively managed Future Fund Active ETF $(FFND)$

"We're looking for transformational opportunities that could develop over the next several years." wrote David Kalis, CFA, partner at The Future Fund.

The race to fee bottoms

Rosenbluth notes that there are approximately 80 U.S. listed ETFs charging a minuscule fee of 0.05% or less. However, CFRA makes the case that fees shouldn't be the sole criteria that investors base their fund selections. The composition of the fund and the record are something to consider as well.

"CFRA believes all things being equal, investors should consider the cheap ETFs in a broad investment style. But with ETF investing, things are usually not equal," the analyst writes.