How to Evaluate an ETF for a 351 Exchange: The Checklist to Get It Right (EP.247)

0:02Peter:We all need to make smart decisions with our money. The Long-Term Investor podcast shows you how by distilling complex financial matters into easily digestible lessons. And now here's your host, Chief Investment Officer at PlanCorp and the author of Making Money Simple, Peter Lazaroff. Welcome back to The Long-Term Investor. This is the third and final episode in my three-part series on ETFs. Now, this series was born out of some questions that were coming from clients that were related to 351 exchanges. Now, we're participating in a 351 exchange during the second quarter with a very large, very well-known fund sponsor.

0:43And in fact, I'm told we're the only RIA with access to this opportunity. So despite having done 351 exchanges in the past, we're pretty excited about this one. Now, if you're not familiar with 351 exchanges, do not worry. I will tell you all about it in this episode, but I think it's helpful to understand the context for why this ETF series began in the first place. And it's that clients would frequently ask us, hey, how do you decide to do a 351 exchange with one fund versus another? And so that is the goal for this episode. By the end of the episode, you're going to understand what a 351 exchange is, as well as how we think about evaluating a 351 exchange opportunity when the ETF is brand new.

1:27After listening, if the strategy interests you, remember that you can always book a call with me and my team by visiting thelongterminvestor.com, and you can even schedule a call by clicking the link at the top of the episode description. So what is a 351 exchange? A 351 exchange simply refers to Section 351 of the Internal Revenue Code, which enables individuals to contribute property such as stocks or ETFs into a newly formed corporation without recognizing capital gains or losses, assuming they meet some specific tests. Now, this part of the Internal Revenue Code was established in 1954, so this isn't exactly a new thing, but technology advancements have really accelerated the ability for fund sponsors to use them more broadly.

2:12So from an investor's perspective, you can think about people who hold positions in their portfolio that they probably would sell if it weren't for the capital gains they would incur. For some people, maybe it's a concentrated stock position that represents an outsized portion of their portfolio and they'd like to be better diversified. Other investors, maybe they don't have a concentrated position, but they're just simply the owner of individual stocks and they've woken up to all this data that shows why individual stocks are just not ideal for long-term investment portfolios and are certainly much riskier than they appear on the surface.

2:47For owners of individual stocks that can meet the Internal Revenue Code guidelines, a 351 exchange lets you contribute those securities to seed the launch of a new ETF without triggering capital gains. So if you contribute a$1 million portfolio of individual stocks, you get back$1 million of the new ETF and your cost basis simply carries into the ETF shares you receive. Now, not only do individual stocks qualify for a 351 exchange, but ETFs do as well. So a typical use case here is an investor who owns a mix of legacy ETFs that no longer align with their long-term investment plan, but the capital gains again prevent them from making a change.

3:29Here, the 351 exchange allows them to exchange their existing ETF shares or even some combination of individual stocks and ETFs for shares of the new ETF while the cost basis remains in place. So in other words, the goal of a 351 exchange from the investor's perspective is to solve a diversification and allocation problem without forcing a taxable sale today. From the fund sponsor's perspective, their goal is just to collect assets. As we first explained in the episode on how ETFs come to market, that is episode 245, launching a new ETF requires the fund sponsor to gather capital commitments from institutions, from advisors, or individual investors ahead of the launch.

4:15And they don't really care if the initial seed capital comes from cash or securities, as long as it brings money in the door and gets the fund off the ground. What I also discussed in episode 245 and how ETFs come to market is what happens when an ETF fails to gather assets. Because if they don't gather enough assets to offset its fixed costs, the sponsor really has two choices. The first is to liquidate the entire portfolio and close the fund. This means the ETF shareholders will receive cash for their shares, but they also would have to recognize the capital gains in those shares. To me, this is the ultimate doomsday scenario that investors really want to avoid.

4:57And honestly, the fund sponsors want to avoid it too. And they often choose a second path, which is merging the ETF into another fund. The benefit here versus a full liquidation is that the capital gains aren't triggered. However, the downside is that the new exposure is often different from what you wanted to own in the first place. And while many mergers are designed to be tax efficient, the tax result ultimately depends on how it's structured and what happens inside the funds during the transition. That's what makes it so important to think carefully when you're considering a newer ETF. There is research that I will link to in the show notes at the longterminvestor.com that shows that most ETFs, when they fail, they fail in the first three years.

5:41And so it's pretty common to see allocators wait to even begin a due diligence process until there is live fund history for at least three years. And another common hurdle that investment teams will consider is an assets under management threshold. So depending on the underlying securities, they may want to see$500 million or a billion dollars in the strategy, just depending on the strategy itself and who the fund sponsor is. But here's the thing, and this is really at the crux of this episode. When you're contributing securities to a new fund via 351 exchange, exchange don't have the benefit of waiting three years or for waiting to see if assets accumulate.

6:21So that is the process I really want to dig into now, and it's how do we choose which 351 exchange we want to participate in and which ones we want to pass on. So most of the 351 opportunities that we've evaluated in the past, we've just simply said no, and it's primarily due to concerns about the new ETF we'd be seeding with those client assets. The evaluation process that we go through for an ETF with no track record really relies on FIT support in trading. And FIT is the easiest one to determine, in my opinion. It's basically, would we want to own this ETF long-term even if there were no 351 exchange involved?

6:58Because if you don't like the ETF as a long-term holding, the tax benefit doesn't really fix that. So in the current 351 exchange opportunity that we're going to be doing in the second quarter, the fund that we're working with is providing a U.S. exposure that looks a lot like something that we already allocate to today. So it's pretty easy for us to see how the strategy matches our client's plan. And the cost is right in line with what we've been targeting over the long term. And when I think about past 351 exchanges we participated in, it's always the same. The fund that we are having clients utilize is aligned with something that we would want to buy anyways and is offered at a reasonable cost.

7:38And so as we're evaluating different opportunities, most of what we see is that, hey, this exposure to a fund doesn't really fit with how we would want to invest our clients' assets. So that's usually the first hurdle. And if it doesn't clear that, then the whole conversation's over. But if it is the type of fund that you would want to own anyways, even if there weren't a 351 exchange involved, well, then you're going to start focusing your due diligence on how likely is the fund to survive and how will the fund trade post launch? And how is the fund sponsor set up to comply with the rules of a 351 exchange?

8:12Now, there are over 20 due diligence questions that I thought about reading. And if I'm being perfectly honest, I did read, but I've now edited out and cut that part out. It just got too boring, but they're all up there on the longterminvestor.com if you want to see some of the questions that we dig in to fund sponsors with. But I think a better way to close out the episode and to close out the ETF series is just to bring it back to the investor's perspective. When we look at 351 exchange opportunities at Plaincorp, we always start with the client's plan. And the holdings that show up are usually the same kind of things too.

8:46Sometimes it's a handful of individual stocks that have grown into a concentrated risk. Sometimes it's ETFs that were bought once upon a time for one reason or another, but today the only reason they're still there is they carry a meaningful gain. And then sometimes it's an SMA that did its job for years and harvested losses early on, but now it's no longer generating losses and it isn't what we'd choose today if we had cash. And that's the key. A 351 exchange is just a great tool for getting from what you happen to own to what you want to own without forcing a big taxable event. Not everyone qualifies and not every holding can be contributed.

9:28And I think sometimes the reason that we say no is just as important as the reason we say yes. If you were thinking about this strategy, there is a lot of thought that needs to go into it. If you would like a hand with it and would like to talk to Plaincorp, again, you can visit thelongterminvestor.com, book a call with me, or you can use a link at the top of the episode description. As always, thank you so much for listening. and until next time to Long-Term Investing.

9:56Peter:Thanks for listening to the Long-Term Investor podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.