Talk Your Book: Finding Tax Alpha in Fixed Income

0:00Today's Animal Spirits Talk Your Book is brought to you by FM Investments. Go to fminvest.com to learn more about their brand new Compounders series of ETFs. Provides you big time tax alpha, no dividends. Big league. fminvest.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:37Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:45Welcome to Animal Spirits with Michael and Ben. Michael, our inboxes are full of tax alpha these days. And ETF providers are getting smart to the fact that they can now make changes that make it more tax advantageous because people really care about paying less in taxes. That's right, Ben. And so FMO Investments has this new series, the Compounder series. I think they told us it comes out August 12th. Sound about right to you? Five days before someone's birthday on this podcast. Not naming names. How old do you turn? 55 almost. Nice. No. So basically the ETF structure just allows you all these different things to do where they can avoid paying out income that you'd have to pay taxes on.

1:27You know, it's funny. I don't want to spoil the episode, but when he told us how they did it, I was like, that's it? But in a good way. It's pretty simple, but it's essentially you can get this same exposure to bonds without having to eat the dividends or income or whatever it is. So, and pay the taxes on them. It's a really cool, and this kind of stuff is just going to, there's going to be more and more of this. So we've talked to Alex before. We talk about a bunch of different things. We get into the Fed and the bond market and short-term T-bills. And we even had a listener question that was very detailed that we get into.

1:59So all this different stuff. And they're constantly tweaking and coming out with new ETFs. And so we always like checking with Alex. He's like the one guy who can make fixed income actually exciting. All right. So here's our talk with Alex Morris from FM Investments.

2:16Alex Morris, welcome back to Animal Spirits. It's great to see you. Tech troubles notwithstanding. Thought we were going to agree we weren't going to tell the listeners about my embarrassing five-minute romp here. That's why I do ETFs and bonds and whatnot. I don't do tech. Well, I appreciate the belly laugh. So, all right. Balchunas tweeted yesterday something about indie, what did he say? Indie issuer on fire. And I would put you all FM in the indie group and you, like a lot of your peers are on fire. What is it about this year? Is it like less regulation? What is the unlock that it seems to be like you all are just doing it?

2:59If we go back, this all started probably 6C11, right, 2017, when the sort of like Cambrian explosion of ETFs started. And it took a while for that to take hold. Rates are an interesting place. But we hit this like great nexus where, yes, there was some regulatory reform coming from the SEC, but there's a need for product. There's now this sense in the market where VIX is low, bond volatility is low. Folks are looking to make a change. And ETFs are the easiest, fastest, now preferred choice of investors to get access to that change. And you notice the change and the fire isn't coming in just one asset class.

3:36It's not just the, as Eric would say, boomer candy, buffered ETFs. It's buffered. It's levered. It's inverse. It's everything. It's precise things that we're doing. It's new flavors of old ideas, right? It's everything everywhere. but three years ago, this is a$7 trillion industry. It's a$12 trillion industry today. That's a pretty massive jump. Yeah, we've talked about a lot of these bull markets and different types of strategies. You mentioned the buffers, the option incomes ones are big. The latest trend we're seeing everywhere, and Michael and I are seeing it in our inbox. We're seeing it in client conversations.

4:07We're seeing it in prospect conversations. It's tax alpha now. And I think a lot of issuers have rightly realized that, listen, beating the market is hard and rich people who are the investors in most cases really hate paying taxes. And if you can make, figure out a way to give them some tax alpha, that is something that a lot of people will perk their ears up to and go, oh, okay. Cause again, we always say people almost hate paying taxes more than they enjoy making money. And that sounds stupid, but it's, it's true for a lot of people. It's absolutely true. You know, and this was one of those moments where we got to kind of go back to the future, you know, working at a family office group called Fortigent here in DC a long time ago, when we sold the business off, we were a large user of Parametric and its tax alpha generating beta strategies, which were kind of all the rage.

4:54And it kind of fell a little bit out of favor as just everything went up and they seemed to lose some steam. But Brent Sullivan and others have done a great job of really commenting on how that works well. And now folks are looking at, well, I like this theory of saving on taxes. That feels good to investors. And ETFs, which are easy, can I combine the two? And you're absolutely right. Investors will make ridiculously dumb decisions, myself included from time to time, not even out of not paying taxes, out of the fear that I might have to pay taxes in the future. So if you can unlock, remove that fear, you kind of unlock the ability to get the asset allocation you want.

5:28And that's what we're looking to do in the compounder series we have. The fixed income side, fixed income is kind of clunky, just in general to own. ETFs fix a chunk of that, but you still have this income that kind of comes in. And we find in our inbox, what was pretty surprising to us was, hey, we like the way you're doing this. We just don't like the distribution schedule. We're paying you to manage the money. Why are you giving it back to us? We just reinvest. It seems like there's 12 needless transactions a year. Can you help us with that? And so we're looking to give that tax alpha tax portability to folks in fixed income by saying you choose how and when to take your distributions.

6:03We're not going to give you a taxable distribution throughout the year. You decide when to take your money out, how much to take out. And if you wait 365 days, take long-term capital gains on it and empower investors to be in that choice because we don't want them to keep making silly decisions because of taxes or the fear of taxes. So you are transforming bond returns into total returns. So you're stripping out the income or you're putting the income back into the product. How does that happen? Exactly what we're doing, right? Folks really want price compounding, particularly long-term investors.

6:32So as opposed to buying the underlying bonds, we'll buy some amount of ETF or an ETF in many cases. And then before it pays its dividend, we'll switch out to a pretty good proxy for it for a few days, and then we'll switch back. So we're basically, while many folks are trying to capture a dividend, and they're doing the exact inverse of us, right? They're trying to jump in the day before the dividend, collect the dividend, and hope that it doesn't lose as much in the NAV as they were paid out in dividend. We're doing the opposite. We're stepping out of the way. So we're the complement to them.

6:59So for the div The chasers were the div avoiders. We don't want the dividend. We just want to see continuous price appreciation in the fund. And the distribution power is to the investor then, not us. Because, you know, in all fairness, us generating cash, giving it to you, you giving it back to us is pretty clunky. And investors are out of the market, sometimes up to a week, which feels seemingly unfair for someone who just wants long-term capital appreciation in an asset allocation model without a lot of rebalancing. And the ETF structure is the thing that unlocks this and allows you to do this strategy easily, right?

7:31Because there's obviously some turnover involved. So explain how the ETF vehicle has sort of unlocked a lot of these strategies. So the ETF is known for tax efficiency, right? And I think folks always equated that to, I'm not going to pay capital gains along the way, responding to mutual funds' obvious miscue in how they were set up. And so the answer is we just avail ourselves of the same function that does that. Think of this as an ongoing tax harvest that's happening, but as opposed to taxes, it's an ongoing dividend avoidance strategy because we just don't want the dividend. We're in it for the capital appreciation.

8:04We want assets that keep going up. So in your bond ETF, every day you get two components. You get the price movement of the bonds and the accrual from the income that they're going to pay out. And they pay that income out periodically. We just leave before they make that distribution. Because if the distribution is received by our ETF, we have to then make that distribution to the underlying investor. If we don't ever receive it in the first place, we get what we're looking for, which is price appreciation. And the investor gets what he or she is looking for, price appreciation and no distribution.

8:35whenever it was convenient for another ETF issuer. So this is for the people that hold bonds for ballast stability, dry powder three balance, not for the people that are using the distributions to live. I assume that because you're calling this the compounder series, that there are multiple points of the curve that you are going to be making this available to. Talk about that. It's the eighth wonder of the world, right? Compound interest. And so So we're compounding that up over time. So as opposed to getting a 1099 for all the distributions that you would get, you're just leaving it all in the ETF, and it will just compound over time.

9:11You choose when to take out, how much to take out, and your own tax status when that happens. We're going to go after the major asset classes that today we do little bits and bots in, but less of them points on the curve. We're going to go for folks who would otherwise buy the aggregate bond index, so something like AGG or the high yield index, where there's a lot of taxable income that we can help compound over a longer period of time, then you'll watch us step out soon in new filing that we're planning to come out to some of the other higher income asset classes that even step beyond traditional fixed income.

9:43All of it in that same sense of if you're buying something for yield, right? You generally love the yield. Yeah. You're forced to deal with the distribution. How can we disconnect those two? So you can enjoy the yield that it gives you, but choose when those distributions happen. So how much of a competition is this to munis? Like, are you on the muni fund block right now where it's like the wire and we've got Avon versus Marlowe, right? Or is this like, is this a problem for munis bonds in the future? I don't think so. We still run a big muni practice. Folks love munis because their income that you receive today and it's tax-free, but munis come with it all sorts of other issues, right?

10:22If you look at the broad muni index, its duration is a little longer than you're going to see in the ag index. There's 25, 27 ,000 plus issuers. So buying munis is really a much more personal state-specific process where you can avoid all income taxes and the code allows for that. But they have different benefits, different liquidity profiles. They're just different. This gives folks who've long time had the option to buy munis, but still bought high yield, still bought aggregate bonds, still bought something investment grade like an LQD, where now they can do that. And as opposed to having to shove that away in their IRA or their 401k program, they can now put that in their taxable account and enjoy the same compounding benefits and now even increase their efficiency.

11:05Because even in your IRA, you're still getting that distribution that's still inefficient for you and you have to rebalance it. And if you forget to do it, now you're just building up cash. We'll take care of all of that in the same way that benchmarked it to simplify ownership of treasuries in this very clean, precise way, but also in this user-friendly, investor-friendly way. That's a good point on the asset location because there's always these rules of thumb about where you should put certain assets, right? Well, these put REITs and bonds into your tax-deferred accounts because that way you don't have to worry about paying on the income.

11:35And it simplifies the asset location piece for people. Exactly. And like I said, taxes cause people to do some pretty wacky things. How do we just stop that? We shouldn't be allowing the tax tail to wag the dog at any point. We should just allow investors the freedom to put the allocation they need and the investment they want in the account that they use and love the most. And we're trying to provide that. And we know others are going to come up with more clever and interesting ways. There are some ways that are out there today that make us a little worried as to how close Icarus is flying to the sun with the tax code.

12:08But this is just stock standard ETF practice management, things we've been doing for a long time, things that active management of fund-to-funds have been doing in ETFs for some time, just now brought to that very clean, very precise exposure to how you want to have access to the fixed income market. It is funny how many people worry about like, well, if they change the tax code on this, I don't know. I feel like we've deregulated everything. And for 30 years, I've heard about how we need to pay more taxes because the debt is too high and taxes just keep falling. So I think everything's going to be fair game.

12:39It's going to be Mad Max in the streets and any, you know, everything goes. If everyone really believed that, at the end of your 1040 form, there is a place where you can make a donation to the government. No one uses it. But practically, you know, the ETF is the most powerful force to hit main street investor, perhaps ever, you know, maybe second only to the bank account. Have you heard of Bitcoin? Yeah, first of all, that's a different innovation, but you have to hit everyone in main street. No income on Bitcoin. They don't have to worry about paying taxes on yield. Not yet, but we'll see. They're coming for you.

13:11But practically, if we were to start playing around with the ETF rules, we've had a hard time even talking about getting ready to carry interest, which impacts what, 1%, 2 % of the population. Could you imagine if we went after the super powerful force of the ETF that's made investing really much simpler, more straightforward, better for the average investor? Yeah, no way. We'd be up in arms. Pitchforks. This idea is so simple, and I mean that in the best way possible. It is brilliant in its simplicity. So there's no execution risk. Is there? One of the first times we met on the show, said the same thing about T-bill.

13:47And so far, so good. I mean, simple things done well over a long period of time often prove much more nuanced and difficult than I think folks that see it first. And sure, there are some practical realities that have to be taken into account here. When we move from one ETF to another, you don't want to move the market. We have to move to a substitute. There's 12 D14 rules around concentration. You don't want to go into something that's a liquid that might have pricing that doesn't work. So although we work with some really smart folks, the former Claymore folks who invented the bullet shares series of ETFs later to Guggenheim and ultimately to Invesco, David Cohen, Matt Patterson, his team, other fixed-thinking innovators, kindred spirits in this same thing of how do you do the simple things that folks forgot to do?

14:29So we work with NASDAQ to make an index. So now you can see how this works. It's not just Armand. It's theirs, and you can see exactly what we're about to do. But there's still some investment management that needs to be done because the index may say, do this, but practically the fund may not be able to do that. Or it might be an unsafe thing to do for investors. And it's our job to step in and decide, how do we optimize that equation? So there is some risk, right? Anytime you're running an ETF and you're buying and selling things, you could stuff that up. And I think we've got some great portfolio managers and some great things in place to prevent that.

14:57And the market could respond, right? Markets could say, you know what? We're going to align div dates together. there, some funds would say, we want to opt out of this. Practically speaking, when other strategies live in this nature of hapt, primarily the div capture strategies, the market's done a really great job of spreading things out to give choice. So why would they opt out? I mean, they're getting flows if it works. Some would. I mean, if we get to the high yield space, right, there could be some small funds who say, hey, we don't want these massive flows for a few days or one month in, one month out.

15:27So there's different things for different folks out there. The largest, most liquid funds would be pretty happy for it. But there is some execution risk that we're going to manage. And$8 billion plus of ETFs later, I think we're well-equipped to do that. But that's why we have three PMs on each strategy, two traders, and folks monitoring this stuff intraday is to make sure that those little pitfalls that might happen are well-avoided. One of the tax alpha strategies that's been coming hard and fast into our inbox, and it seems like people are lining up to roll them out these days, is these 351 exchanges.

15:59What do you think about that as a vehicle? And what are some of the challenges? Because at face value, it seems like an amazing deal. But there's more that goes into it than meets the eye once you dig into the details. Yeah, so 351 is part of that code along with 1031K where you can make these like-kind transactions. And on its face, they make a lot of sense. There's some rules against taking, you need to bring in a diversified basket. Right, you can't just have one stock, which would be great, but there's rules, right? Right. Yeah. You have to bring in a diversified basket of securities because the government doesn't want to give you a free trade.

16:32They're saying, look, if you bring in a diversified basket and you own by the rules that govern ETFs by default, a diversified basket, no harm or foul. We're pretty cool with that. But now you've got all your bases there. Maybe that basis gets washed out, maybe not. And now what happens, you have to sell the thing. You still have the basis of your stock that you brought into it or bonds or whatever assets you brought into the fund. So it's not like it goes away. You're getting a deferral. And if it turns out that the investment you chose you don't like, you're now stuck. You have to now look for another 351 transfer to do this.

17:06And the daisy chain goes on. So there's some great parts to it. But the thing we remind folks about, whether it's Compounder, whether it was the beta management we did at Parametric, these things all have to first be good investments. If you're just going from, I don't want to pay taxes. I'm afraid. I'm going to go to this thing because I think I might pay less in taxes. that's not a great idea. You have to make sure the thing you're buying is first a great investment and the right investment for you. Otherwise, you're just exchanging one set of problems for a whole new, maybe bigger set of problems.

17:36Sure. You're going to save on some taxes today. You might defer some, you might change the character of some, but if the investment stinks, it stinks. Alex, we got a question from a listener. Since inception in February, the R bill is up 1.5 % and the T-bill is up 1.7%. I was shocked by this given that the CPI index is up 1.2 % year to date, but more importantly, inflation expectations during the year have soared. We all know that the gravy in tips is not what actual inflation is doing. If you bought a tip that had baked into the price of the assumption of what CPI was going to be in the future, then you didn't get any upside in owning tips.

18:12You simply get the real return. So all is equal tips total return will lag T-bills return because T-bill returns are not inflation adjusted. here's the weird part. There's a lot in here, by the way, so forgive me. Here's the weird part. One-year inflation swaps have soared this year. In February, the one-year inflation swap was 2.9%. It's 3.4%. We would expect that the price of one-year tips should be bid up because of this, but based on the returns I quoted above, they have not. So either the assumption being built into the one-year or less tips that are being put into the ETF were so good at expecting the one-year inflation forward already, or something fishy is going on.

18:49I know five months is too early to judge an ETF, but I got to tell you, when I first heard about the R-Bill, I was thinking, man, this is so good, but now I'm apprehensive. Did you get all that or should I read it again? This person is very in the weeds here, huh? Yeah, this is impressive. I may need to read that two or three times. The short answer is R-Bill, if we look at it versus, say, a six-month bill, which is probably - Remind people, I don't think we said it. This is an ultra-short tips fund, right? Right. Ultra short tips, tips exclusively 13 months or less. Reason why by 13 months, now 12, is a lot of tips fall out of indices when they become 12 months old.

19:22So a lot of folks sell them in that sort of 13-month expiry. So they're very cheap to buy and acquire. What I would challenge the listener who very clearly has done his or her homework is to really look at it less to the T-bill market and more to the six-month bill market. because the average duration of the portfolio is closer to six months to maturity or six months, it's called average duration of five on that six-month bill, than it is to the actual T-bill itself, which would be 90 days or slightly less. And those two track each other pretty closely. You're not going to get that pure T-bill market because there are some of those swaps in there.

19:53Don't forget, many of the bonds we own are nine, 10, maybe 29 years old. So they have some different coupon rates. So they behave slightly differently day to day. But if they went back and looked at it versus its six-month counterpart, which is closer to its average duration, you're going to find they chase each other every day pretty closely. Now, let's also look at our bill itself versus its underlying index, which it's actually beaten its index even net of fees, which is, I think, a byproduct of some of the trading and that inefficiency of when these things come in cheap and how we can hold on to them and acquire them there.

20:26I would warn folks, once you get into the inflation market, it's rarely exactly what meets the eye. In general, though, it's run by some, there's a lot of really smart market participants. So it can be priced really, really well. We've had some inflation and inflation expectations have moderated some, they're still high. Inflation has generally been a little soft though. So the inflation expectation numbers as priced into longer term swaps was, let's say, a slight miss. But then when you look at the actual shorter-term inflation expectations, all of the numbers came in soft three, four readings in a row.

21:01And despite that, our bill still has a meaningful positive return, like I said, versus its six-month, chases that thing day for day. Versus the T-bill, though, T-bills have just been so profitable as a trade given there's so much supply of T-bills. And that trade sort of has some supply and demand there. And Tebel itself has done a pretty decent job of harvesting some yield in the market, making some great rolls, and taking advantage of some of the market makers and some of the primary dealers who had excess supply and were willing to sell it to us cheap because they wanted off their balance sheet.

21:33So there are a couple of factors there. But I think, long story short, go back and look at X bill versus R bill, and I think you'll see the story. And that's probably the better comparator. So that question asks about inflation expectations as well. And I don't know if they're using the actual bond market to talk about those inflation expectations or the survey results, because obviously the survey results, what people think inflation is going to be, are sometimes wildly different. Based on this email, they're probably using the bond market. Okay. I mean, that was a pretty sophisticated email.