My Latest Tax Avoidance Scheme

The latest hotness in ETFs is figuring out new and novel ways to not pay taxes for as long as possible.

After writing that first sentence I’m realizing that ETFs have always been used to avoid paying taxes for as long as possible. It’s the main reason why most mutual funds are converting to the ETF structure.

But the latest novel use of ETFs is structuring them so interest accrues and is converted into long-term capital gains when you go to sell instead of paying out on a regular basis and getting taxed each year.

Enter F/m Compoundr’s latest ETFs

F/m Investments has launched a novel ETF structure called Compoundr. Instead of holding individual bonds in a plain vanilla ETF wrapper, these funds invest in bond ETFs (acting as a fund-of-funds) with a deliberate rotation around dividend dates to avoid receiving distributions.

How It Works

1. Core Position: The ETF holds Aggregate Bond ETF A.

2. Rotate Pre-Ex-Dividend: Just before ETF A goes ex-dividend—but while the dividend is still embedded in its NAV—the fund sells ETF A and buys a “Substitute” ETF B.

3. Rotate Back: After the dividend has been paid out, the fund switches back to ETF.

The result is no distributions: By never actually receiving dividends, the fund accumulates full total returns—emulating the behavior of a European-style accumulating ETF or a total-return ETN. This is especially beneficial for taxable accounts where an investor doesn’t necessarily want current income but does want the buffer that bonds often provide to an overall portfolio.

Broader Impact

F/m launched both CPAG and CPHY earlier in August. CPAG is an aggregate bond index while CPHY is a high yield index. Both of those have large enough and deep enough ETFs to switch between that there shouldn’t be much friction. And while CPAG’s daily volume is pretty low right now, the spread is generally just a penny apart, which makes it pretty easy to get your dollars in.

With a 30-day SEC yield on AGG of 4.32%, less the 0.45% management fee of CPAG, not having to pay annual taxes on it effectively takes the equivalent pre-tax yield to ~5.95% plus it converts the accumulated interest to capital gains so with tax loss harvesting (not that I would ever experience a loss on any of my investments :P) I have the potential to turn that into tax-free interest income.

The only thing that could make someone hesitate is that CPAG charges a 0.45% management fee vs AGG’s 0.03%. With the expense ratio being what it is I wouldn’t go all-in on it, but I bet that management fee comes down over time between increased competition and AUM not growing as fast as they hope since there’s only a small sub-set of investors where that really moves the needle for them.

Long-term Impact

The one thought I’ll leave you with: does this end up having an impact on the spread between municipal bonds and regular bonds?

Ie, does the interest demanded to take on the risk of muni debt increase to where it has the same spread as the same risk-rated corporate or Treasury debt if the tax implications are effectively equivalent?