INVESTING
the actual launch whereby advisors and investors can deliver their investment portfolio to the fund company and receive shares in the new ETF . “ Section 351 allows investors to exchange a portfolio of securities for shares in a new ETF . And if done correctly , the transaction can be tax-free ,” says Wesley R . Gray , Ph . D ., the CEO at Alpha Architect .
Gray likens the strategy to a 1031 exchange , which allows real estate investors to sell a property and replace it with a similar property without triggering any tax consequences . This allows investors to defer any potential capital gains tax until a later date . ETF investors can receive a similar benefit plugging into Section 351 .
ETFs using this strategy are being deployed in a variety of ways . For instance , registered investment advisors can use such ETF wrappers to make their own investment services more efficient . Instead of offering asset management inside a separately managed account , an advisor could create their own ETF and offer it to clients .
Another strategy used by RIAs is to contribute their client ’ s assets to a Section 351 ETF during the fund ’ s seeding period , just before its launch date . This latter strategy is easier for RIAs than building and managing their own ETF .
This latter model was offered by asset manager Cambria Investment Management to RIA firms last month when it launched the Cambria Tax Aware ETF ( TAX ). The $ 27 million ETF was seeded by individual investors and advisors exchanging portfolio holdings for the new ETF . The investment strategy of the Cambria fund is focused on U . S . stocks with value and quality characteristics .
“ We ’ re thrilled with the strong initial interest in TAX from both investors and advisors ,” says Meb Faber , co-founder and CIO of Cambria . “ Beyond the tax benefits of the seeding process , the fund ’ s focus on value , quality , and tax efficiency makes it an attractive option for a wide range of investors .”
While seeding periods can vary , they generally will last a few months ahead of an ETF ’ s actual launch date . After the ETF is launched , the fund can be purchased by anyone in the open market , but the process of delivering an investment portfolio for new ETF shares ends .
What type of investor might this new class of ETFs appeal to ? Those with the highest effective tax rates and portfolios with large unrealized gains .
According to Sullivan ’ s latest data , six ETFs from Alpha Architect , Cambria and Tema ETFs are slated to open for seeding via Section 351 transfers during the first half of 2025 . Among this group is the Alpha Architect U . S . Equity ETF ( AAUS ), whose projected launch date is May 1 , 2025 . The fund is an actively managed broad U . S . equity product .
What type of investor might this new class of ETFs appeal to ? Generally , it ’ s those with the highest effective tax rates , people who also have portfolios with large unrealized gains . Advisors whose clients fit this profile could help the clients organize and consolidate assets — as well as potentially cut a big tax bill .
After contributing their in-kind assets , the investors ’ cost basis and holding period should translate directly from current holdings to ETF shares . If an investor is contributing significantly appreciated shares , their new shares in the ETF will also be significantly appreciated , and the net asset value of the ETF will be higher than the ETF ’ s cost basis .
Beyond the ETF firms ’ expense ratios , there are generally no additional or direct costs paid by investors for seeding .
Before deciding whether it makes sense to participate in seeding an ETF with an in-kind transfer , advisors can educate clients and perform due diligence on the vehicle ahead of time . For example , certain ETFs may not have any performance history , but they could have a related mutual fund cousin that does , which would offer an indication of what to expect .
The ETF sponsors are eager to help out , too . Before initiating a 351 in-kind transfer , advisors can contact an ETF sponsor directly for the mechanics of how to proceed . And the firms can help an advisor determine whether a client ’ s portfolio is a good candidate for this conversion strategy .
In the end , advisors are the bridge to this new category of tax-friendly ETFs .
RON DELEGGE II is the founder of ETFguide . com and author of several books , including Habits of the Investing Greats and Portfolio Architecture : A Handbook for Investors .
40 | FINANCIAL ADVISOR MAGAZINE | JANUARY / FEBRUARY 2025 WWW . FA-MAG . COM