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The Big Apple Spin on ETF Conversions

In the bustling world of finance, New Yorkers are catching onto something enormous: the appreciated assets locked in tax limbo from capital gains in separately managed accounts (SMAs). A recent study lays out this massive opportunity for ETF conversions.

Section 351: The Quiet Revolution

The Cerulli Associates report highlights $2.7 trillion in SMA holdings. Among this, $1.6 trillion belongs to wirehouse clients and $484 billion rests with registered investment advisory firms’ customers. These could benefit from moving to a more tax-efficient solution. After all, who really enjoys paying taxes on their investments? Enter the increasingly popular Section 351 conversions. This nifty tax code provision defers capital gains and brings about lower costs and more efficiency.

The Mechanics of Conversion

However, experts caution that the path isn’t without hurdles. Why? Because the process is technically challenging and governed by strict compliance rules. The assets need diversification attention, and let’s face it, not every advisor should—or even could—dive into this. Wes Gray, the CEO of ETF Architect, who’s a bit of a tax-slashing ETF trailblazer, remarks on the complexity: “It’s a lot of work; it’s not just pushing buttons.”

Tech and Transition

To help with this, wealth and investment technology firms like ETF Architect, Tidal Financial Group, and others step in. They’re driving the ETF launches, assisting advisors and firms to migrate assets smoothly. Case in point: Eagle Capital Management sparked industry interest by converting $1.8 billion in SMA assets into the EAGL ETF.

Smoothing Out Operational Complexities

These conversions act as an “exit valve” for separate accounts that have maxed out on tax-loss harvesting or become too cumbersome to manage. They step in as efficiency tools for advisors, providing strategies for clients and allowing fee charges.

Direct indexing in SMAs was once thought to compete with ETFs. But, with conversions gaining attention due to their capabilities, the asset pool in individual securities could generate a staggering $9.5 trillion flow into ETFs.

RIA M&A: Merging Assets

Now, let’s talk mergers. The bustling world of RIA mergers and acquisitions finds a boon in transfers. They help acquirers combine assets into an ETF, scaling up strategies. It’s an “interesting theme to keep an eye on,” remarks Daniil Shapiro from Cerulli Associates. He points out, “You’ll likely see discussions between ETF issuers and scaled RIA firms.”

The Road Ahead: Challenges and Opportunities

With numerous logistical hurdles and regulatory hoops to jump through, the process isn’t a cakewalk. Formal client permission, record-keeping, custodian coordination, and asset adequacy are just a few of the tasks on the agenda.

However, Gray believes Cerulli’s $2.7 trillion figure might not be a stretch. With potential SEC approval for ETF share classes in mutual funds on the horizon, even more transfers could be on the cards.

What’s Next?

For SMA investors, the grind of managing “Frankenstein portfolios” could become a thing of the past. As Gray puts it, “All the 351 does is allowing capital to flow freely.” The upcoming changes could bring relief from operational complexities. Yet, he warns: “Folks without a solid value proposition will face massive exposure.”

In the Big Apple’s fast-paced world, this conversion trend seems like something to watch. Stay tuned!

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