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ETF providers may find a silver lining after 2022’s brutal first half with some US investors who took significant losses in mutual funds during the period looking to transition their assets to ETFs, executives said.
This is particularly true with fixed-income funds, which during the first six months of this year experienced the worst drawdown the products have seen in 30 years, executives said. Investors who have experienced huge gains in active bond mutual funds since the 2008-2009 financial crisis may have an opportunity to take losses in recent fund purchases, combined with embedded gains, and move that money into lower-cost options.
“You can wrapper-swap through tax-loss harvesting from expensive mutual funds into ETFs, which are lower cost and more tax-efficient,” said Todd Sohn, managing director of technical strategy at Strategas, an institutional broker-dealer and advisory firm.
Many investors are selling out of bond mutual funds while still buying bond ETFs. The redemptions from US fixed-income funds so far this year are significant, amounting to more than $205bn in the first half of this year, according to Morningstar Direct data. The $137.5bn pulled out in the second quarter accounted for the second-worst sales quarter since 1993. Bond funds’ net outflows were only greater in the first quarter of 2020, when the coronavirus pandemic spurred volatile markets.
Sales have slowed for taxable bond ETFs, which attracted $53.8bn in net inflows during the first half, according to Morningstar’s database.
Embedded gains in longstanding mutual fund holdings are “probably the biggest obstacle whenever we speak with advisers who are looking to rebalance or use more ETFs”, said Michael Lane, head of iShares US wealth advisory at BlackRock.
Targeted tax-loss harvesting — selling securities at a loss in order to offset capital gains tax due on the sale of other securities — is a perennial discussion for ETF shops, because the vehicles serve as a temporary parking spot for assets in transition. But the opportunities to do tax-loss harvesting have been limited and relatively shortlived, Lane said, such as in the spring of 2020 amid the pandemic-driven stock market meltdown.
But today the extended nature of the market downturn has given advisers more time to think about the strategy, and in fixed income, to look at how active managers have navigated the pullback, he noted. “Some people have said: ‘I can have some more precision in my exposure and take more control in my portfolio via ETFs,’” Lane said.
Vanguard, too, has seen fixed-income repositioning dominate discussions with advisers, with some using ETFs to facilitate that, said Ryan Barksdale, head of portfolio analytics and consulting at the Malvern, Pennsylvania-based fund shop.
“Ninety per cent of conversations with advisers are on the fixed-income side,” Barksdale said. “The reality is that tax-loss harvesting in fixed income hasn’t really been a thing or the potential to be a thing until recently.”
Index funds are appealing to some advisers “for portfolio efficiency, and reducing the due diligence burden of looking across a number of active funds”, Barksdale said. But advisers also use the negative returns in bonds to reassess where they are taking risk and whether they want to keep with that stance or rebalance it, he added.
Investors have become quite comfortable with using the ETF structure for investing in bonds, executives and analysts noted. Bond ETFs have been criticised in the past for being “extremely dangerous” and having the potential to seize during periods of market stress. But the pandemic-sparked meltdown in the Treasury market increased investors’ confidence in bond ETFs.
“March 2020 was a great stress test, and bond ETFs did what they were supposed to do,” Strategas’s Sohn said. Spreads widened and ETFs traded at a discount to net asset value, but ETFs ultimately proved to have better liquidity than the underlying holdings, he noted.
Equities, too, are ripe for ETF disruption via tax-loss harvesting, sources noted. But not all ETF sponsors see it as an opportunity to wrest share from mutual funds. Rival ETFs also are ripe targets.
The $11mn Future Fund, a thematic technology ETF launched last August, is positioning itself as a resting place for investors looking to harvest the big fall in value of the $9.6bn Ark Innovation ETF, said Gary Black, managing partner of the ETF’s investment adviser, also named The Future Fund.
“You’re at least exposed to these megathemes — finding great innovation and disruptive companies — but much more disciplined from a value perspective,” Black argued.
More broadly, Black, the former chief executive of Janus and co-chief investment officer of Calamos, said that the steep downturn is the perfect environment for mutual fund managers to “cannibalise themselves” and get investors to move into ETF versions of their funds before investors depart for rival ETF shops.
“We’ve long been saying the ETF is a better vehicle, a more efficient vehicle for active management, and this year there’s going to be a lot of tax-loss selling out of mutual funds and into ETFs,” Black said. “If [mutual fund managers] don’t have a product that’s similar, they’re going to lose out.”
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