At the Money: Deferring Capital Gains on Appreciated Equity

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1:15Some investors have big concentrated equity positions that have accrued big gains. Maybe it's due to employee stock option plans. Perhaps they have some founder stock from a startup. Maybe there was an IPO or a takeover. But suddenly they find themselves sitting on an uncomfortably large percentage of their portfolio in a single name. The challenge for investors is how can they diversify when selling shares leads to owing big capital gains? What's an investor to do? I'm Barry Ritholtz, and on today's edition of At The Money, we're going to discuss how to manage concentrated equity positions with an eye towards diversification and managing big capital gains taxes.

2:03To help us unpack all of this and what it means for your portfolio, let's bring in Meb Faber. He's the founder and chief investment officer of Cambria. The fund runs 15 ETFs and manages nearly$3 billion in assets. Their new ETF is coming out in December 2024. The Cambria Tax Aware ETF, Symbol Tax, is a solution to address just these challenges of concentrated positions. So, Meb, let's just start with a basic question. Tell us what a concentrated position is. Well, it's a romping, stomping bull market. I know most investors don't feel like it, but a lot of people have had stocks go up a lot. Listeners, think to 2009, the bottom.

2:51At the bottom, stocks have almost been a 10-bagger. And that's the broad market. So individual stocks like Nvidia or Apple or others probably have gone up much more. And the way math works, you end up with a stock that goes up a bunch. It gets to be a bigger, bigger percentage of your portfolio. And that becomes a problem because you're no longer diversified. But so many investors, their response to that is, I can't sell it because Uncle Sam is going to kill me. The IRS is going to kill me. Warren Buffett talks about this all the time on concentrated positions. And it becomes a problem. You get lopsided in your portfolio, and then many investors simply feel stuck.

3:31So let's talk a little bit about what the historical solutions have been. First, you could pay for a collar that sort of locks your stock price in. It doesn't mean you're not going to pay capital gains tax. It just tells you if this stock collapses, well, the expensive put you bought will cover it. But you're still going to end up owing capital gains taxes. or some people write covered calls as a way to offset some of that risk, you still have the risk that the stock could drop, or you have the risk the stock could get called away if it runs up and you're paying the gains. Either way, none of these solutions are optimal.

4:13Tell us a little bit about the thinking behind the tax-aware ETF. So if you go back almost 100 years and talk to any real estate investor, One of the ways they've built generational wealth is the famous 1031 exchange, where you buy a building, you buy a hotel, and you're able to sell it, swap it for a new property, and that is not a taxable transaction. Amazing, right? Now, in stocks, there's been something not too dissimilar called the exchange fund. Been around, really, since the 1970s. Eaton Vance, Goldman Sachs, Merrill have been putting out a lot of these. The problem with those, you've got to be accredited or qualified.

4:52That means rich. You got to hold it for seven years. And usually they're just loaded with fees. They're set up fees. They're usually going to charge you a percent and a half a year. And you end up with a portfolio of just whatever people have contributed. So it's still problematic, not a great solution. And so there's another acronym, another term, 351, which has been in the tax code for almost 100 years, but really hasn't seen a lot of development until the last 10 years. and then increasingly so with the ETF rule. And really this concept has been a lot of prior art. There's been over 100 of these.

5:33First one maybe about a decade ago, but you've really seen it with mutual fund ETF conversions, separate account ETF conversions. And what we're announcing is an open enrollment seeding of an ETF with this 351 conversion. So let's discuss how this works. I'm sitting on a load of NVIDIA or Microsoft or some other highly appreciated stock, and I want to get diversified rather than sell and pay the 23 % long-term capital gains tax. I could tender these shares to Cambria, and they will use it in part of a broader ETF. So I'm not selling it, and I'm getting diversification without paying the tax. Explain how that works.

6:16Yeah. So you can't, let's say Barry's got 10 million NVIDIA. You can't just chuck all this NVIDIA into the fund and see the ETF. What happens is there's two main rules to qualify. The first is no position can be above 25%. Of my portfolio or of the ETF? Correct. Correct. Of your portfolio. Second is anything that's over 5 % has to be less than 50%. So you could put in your NVIDIA, your Apple, but really, you probably got to have a somewhat diversified portfolio. Let's say you could do 11 stocks, maybe. Now, what's nice is ETFs are look through or pass through. So you could contribute SPY or another ETF, the Qs, 100 % of that because it's a look through into the underlying companies.

7:04So the concept that we've come to put together is we're going to gather up all these investors. So individuals, financial advisors who have clients with highly appreciated stock portfolios, cobble them all together, put them into the seed of the new ETF. And after the ETF launches, you then have that ETF running. It's actually the first of three funds. And it's going to be sort of a consistent timeline of open enrollment for the people who want to contribute. You have to contribute to get the tax benefits when the fund launches. and then you get an ETF in return. And the benefit is a tax deferral.

7:42It's not a taxable transaction from ceding the fund to getting the ETF in return. Right. So to clarify this, you're not escaping the taxes. You're just not paying them until you sell that ETF. So your cost basis, all those other things just get transferred to the ETF and on a dollar-for-dollar basis. Is that accurate? Yeah. And it's clear that the ETF structure up and running, so even if you just go buy an ETF, is a vastly superior structure than a mutual fund. Merrill this summer was saying that just the structure alone in a taxable account is probably a one percentage point advantage in an equity fund because you're not paying consistent capital gains.

8:25SPY hasn't paid a capital gain since its launch in the 1990s. And on average, the average ETF won't be paying any capital gains because of that in-kind creation redemption mechanism. So this combines the best features of, hey, seeding a fund tax efficiently and then running it tax efficiently as well. So does it matter if I'm tendering to you a large cap growth stock like NVIDIA or a small cap biotech or a mid cap retailer? Are you thinking about putting together different types of funds, different types of sectors for this? Yeah. So the first fund is also a unique fund and it's a U.S. stock fund.

9:06And we did a paper about a decade ago. I don't think anyone read it, but it was about tax optimization with the ETF structure. Academic literature, there's actually not that much that targets tax optimization that acknowledges the ETF structure. Most of it just assumes you're in a separate account. And so the ETF structure allows you to do certain things. And so this fund will actually target U.S. stocks that are value or quality stocks, but that do not pay high dividends. And said differently, we want the dividend yield on this fund to be as close or at zero. Because if you're a taxable investor in my home state of California, your home state, chances are, if you're taxable, you don't want 4%, 6%, 8%, 10 % dividend yields.

9:51You have to pay those every year. So ideally, being able to defer the dividend, turn those into capital gains and defer them is also a huge benefit. So that's the first fund, U.S. stock fund. Second fund will be a diversified ETF portfolio. Third fund will be a global stock fund. And then four, five, six will be whatever Barry requests. So when you say diversified ETF, instead of tending you my NVIDIA, I can tender my Qs, and what I get back in exchange will be a fund of ETFs, an ETF of ETFs? Yeah. So the cool part is this has been done. We're partnering with the good crew at ETF Architect. It's a bunch of Marines.

10:32They have that military efficiency. The last one of these they did for an asset manager had 5 ,000 accounts. Wow. So incredible ability to herd cats, put all this together. And so, yes, for the first fund, ideally, it's mid-large cap U.S. stocks. But you could do ETFs because they're pass-through. So if you contribute SPY, that's fine because it owns the underlying securities. If you contribute the Qs, I know you still got a bunch of GameStop, you could contribute that, right? But on the second fund, it'll be more of a global portfolio. You can't contribute private assets. You can't contribute your Dogecoin.

11:07and you can't contribute futures, options, things like that. But in general, stocks, ETFs are A-OK. So let's talk a little bit about the management of the actual ETF when it's U.S. stocks. How do you figure out what of the tendered stocks you want to keep and what you want to get rid of? It's not just going to be random what everybody happens to present to you. You're going to organize this around some key investing principles, I assume. Everything we do at Cambria is systematic rules-based. We like to call it in-house indexing. And so this fund will be a quarterly rebalance, 100 stocks. And again, it's targeting value quality companies that pay low to no dividend.

11:53And you're going to see a big sea change in the next three to five years of asset managers and RIAs, optimizing taxable tax and then non-taxable retirement accounts for various type of investments. Look, they've always done this. We've always done this. But even to a higher extreme, we've done the math on some of these high yield portfolios and taxable accounts. And if you can invest in something like a high dividend yield fund or a REIT strategy, something with a lot of yield and a taxable account, but not pay any yield, you can outperform on an after-tax basis by multiple percentage points. In some cases, it's as high as three.

12:34And so with all this focus on expense ratio, with all this focus on that just headline, what is the cost of my fund? Most people ignore taxes, which can be order of magnitude bigger than a decision to pay something like an expense ratio. So this fund targeting no to low-yielding stocks, maybe not the most marketable idea on the planet, but something that on an after-tax basis makes a lot of sense. And so when someone tenders either an ETF or stocks to you, they may or may not end up in the final ETF. You have the ability to do in-kind exchange. So if you decide to sell it and replace it with something else, there are no taxes to either the person that contributed that or the ETF.

13:17You're just swapping Microsoft for Amazon, whatever it happens to be. That's also a tax-free transaction. Is that right? And this is why so many mutual funds have converted to ETFs. So there was a hundred billion of conversions last year. The most famous probably is DFA. They did about 50 billion of mutual fund conversions. Because mutual funds, if you have turnover, you're going to have to pay out those capital gains. And so every year, about the end of the year, you get these notices. Here's my expected capital gains in this mutual fund. And then you look over at the ETF landscape and you see across the board, almost always zero.

13:55This is why we say, to borrow a phrase from Marc Andreessen, ETFs are eating the asset management industry. It's simply a better structure. So because of this creation redemption mechanism, these funds can be managed and run tax efficiently with no capital gains distributions. Yeah, our preference in the office is the 401ks and 403bs. If they want to own mutual funds, they're welcome. but the taxable account, the preference, anytime there's a choice, we always pick the ETF over the mutual fund. Those phantom gains are pretty amazing. So final question. One of the things I'm aware of is that accredited investors, wealthy investors, have been able to do this with separately managed accounts, where they're essentially exchanging highly appreciated stock for a broader, diversified portfolio without incurring capital gains tax.

14:50How are they able to do that all these years? I know that this is not very uncommon, but it's taken place for quite a while. The main tool is the exchange fund, which has really been around since the 1970s. Eaton Vance, Goldman Sachs, Merrill Lynch have been doing this for their accredited and qualified clients. You got$100 million of Tesla. You can submit it to this fund, you get 100 of your buddies to submit their stocks, you end up a portfolio of what everyone submitted. But the rules are, you have to hold it for seven years, you end up with just whatever these people have contributed, usually it reflects the S &P or the Qs or something like that.

15:27But the biggest problem, and across the board, there are massive fees. There's fees to set up the fund, there's usually the management fee is a percent and a half or 2 % per year, on average. And then at the end of it, you get distributed at those stocks. So not the most ideal situation, maybe better than sitting on a concentrated portfolio. But the exchange fund has been around for a long time for these accredited qualified investors. And we're trying to bring this to the masses and make it hopefully available for anyone. So last question. It's a fascinating idea. I know your colleagues over at ETF Architect, Wes Gray and others.

16:03How on earth did you guys come up with this? So Wes works with a lawyer named Bob Elwood. We did a podcast with Wes and Bob in February this year that did a deep dive on 351 transactions. Because like yourself, I wasn't that deeply knowledgeable about this phrase. I'd never really heard it before. But it turns out he did the first one a decade ago. And he's done about 100 cents. I was chatting with folks at NASDAQ. They said there's been multiple hundreds of these. But usually it's a closed door, hey, I have a fund or I have a couple of accounts here. It's going to be my clients. Our innovation that I said to Wes, I said, Wes, why can't we do this?

16:42Why can't we open this up, open enrollment to everyone to contribute? And he says, I think we can, man. But again, you need that military efficiency of all these Marines at ETF Architect to be able to cobble together thousands of accounts and keep this available to everyone, which should be the first of many funds. So to wrap up, investors with concentrated equity positions that have appreciated a great deal should consider a form of diversification that doesn't force them into Uncle Sam's arms. That's any form of 351 exchange. So perhaps the Cambria Tax Aware ETF, ticker TAX, might be a solution to address the challenge of your concentrated position.

17:26I'm Barry Ritholtz, and this is Bloomberg's At The Money. Yeah, I'm the tax man

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